It would be a vast understatement to say we are living in uncertain times. The U.S. is engaged in direct negotiations with North Korea, while imposing tariffs on our allies and beginning a trade war with China. The geopolitical order as we know it is upside down.
Additional risks have also materialized in recent months. Emerging market countries such as Argentina and Turkey have raised rates to protect their currencies against global capital flight. Harkening back to the European debt crisis of 2011, questions about the European currency have also re-emerged this year following Italy’s most recent elections.
Against this backdrop, we would expect the U.S. Treasury—particularly the 10-Year Treasury—to act as a “haven” asset. Meaning, demand to hold “safe” Treasuries would spike in a rocky investment environment. This in turn would put downward pressure on yields. However, while geopolitical factors influence the long-end of the Treasury market in the short-term, U.S. monetary and fiscal policy determine the path over the long-term. And both policies are pointing to higher yields.
The Fed is now signaling two additional rate hikes in 2018. The Fed is also continuing to unwind its balance sheet with so-called Quantitative Tightening expected to reach a pace of $50 billion a month by the end of the year. In Washington, deficit spending continues to grow, with the recent tax cut only adding to the pressure on interest rates over the long term.
Tariffs, potential trade wars, and geopolitical uncertainty will create temporary demand for the Treasury, but the long-term trajectory seems tilted firmly towards higher rates. This dynamic will continue to weigh on the performance of traditional fixed income. Investors must look at core floating-rate loans to combat mounting interest rate risk. These loans have a floating-rate coupon that reacts to market rate increases, offering the potential for incremental interest income.