“New” Divergences

Non-USD bonds get an upgrade to start 2016, our sole change to begin the year. Significant dollar appreciation as well as appreciation expectations provide a more balanced outlook for FX returns (a significant detractor in 2015). More accommodative monetary policy abroad furthermore raises the attractiveness of non-USD investments for 2016. Figure 8 below captures the notions of a more uncertain outlook for the dollar in 2016. Recall  that the “divergences“ theme in 2015 was a consensus view that diverging monetary policy with the Fed tightening while the ECB and the BOJ expanded their accommodation would lead to a stronger dollar. While that played out in 2015 with the trade weighted dollar increasing by 11.8%, in 2014 it had already increased by 10.5% anticipating those divergences. Hence, as we look ahead to 2016 much of the divergences expectations could be argued to already be in the price. The figure supports this notion by highlighting how in many past tightening cycles, the peak of dollar appreciation was marked by the first tightening in a currency version of “buy the rumor, sell the news” outcome. However, in the big dollar valuation cycle of 1980 we saw substantial further valuation improvement after the Fed tightened. The historical record is thus mixed when it comes to the dollar outlook. “Divergences” alone is unlikely to provide the same fuel for dollar appreciation as in past years, leaving a more balanced view for non-USD fixed income investing for dollar based investors relative to past years.

Fixed Income Portfolio Recommendations To Start 2016

Yield curve steepeners and TIPS breakeven inflation strategies likely perform best in the above scenario of inflation surprising to the upside. However, given the lower likelihood we attribute to this scenario, we see that more as a risk and currently position neutral TIPS while favoring a flattening yield curve outlook when considering the full year outlook. Rounding out our other recommendations to start 2016, most carry over from the end of 2015. We continue to favor credit exposures to the U.S. consumer and to U.S. residential and commercial real estate. Partly this is due to their relative remoteness from the epicenter of the current credit cycle: China, commodities and, more broadly, EM. That leads us to treat credit exposures defensively. But a repricing wider of many of these sectors improves relative value and we start the year generally neutral across High Yield, Bank Loans and IG but anticipate moving tactically between neutral and underweight until a greater realization of the credit cycle increases the value offered by these sectors. We additionally continue a defensive stance on liquidity favoring the higher liquid value of global rates positions vs. credit. That makes non-USD bonds more attractive, and despite the headwinds of a potential for further dollar strength in 2016, much of that strength already occurred and is reflected in the price. Furthermore, developed market non-USD bonds benefit from the more accommodative monetary policies of the European Central Bank and the Bank of Japan. Finally, given our more cautious stance on credit, for sources of income we prefer going down in capital structure in higher quality sectors. That highlights preferreds in the corporate sector as a better source of yield to start 2016.


Jeffrey Rosenberg is managing director and chief investment strategist for fixed income at BlackRock.

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