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Trump reshuffles bond market

The Republican victory may have sparked a transition from a phase of rock-bottom interest rates to a phase of merely low interest rates.

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Editorial

Fixed Income

Investors certainly can't accuse Trump of failing to leave an impression. Trump's election has driven the trade-weighted U.S. dollar index to a 13-year high and pushed the yield on 10-year U.S. Treasuries past the 2.5% threshold last seen in 2014. Investors are showering the future president with premature praise and placing their bets on a fiscal package. The current increase in yields, however, is not only the result of higher growth expectations, but almost half of the rise is due to higher inflation expectations. Still, after fearing the specter of deflation for such a long time, any increase in yield is welcome. At least as long as inflation rates refrain from shooting towards three percent, which we do not expect in 2017. Nor do we expect Trump's economic policy to have much of an impact on gross domestic product (GDP) next year. The triad of tax cuts, deregulation and infrastructure projects certainly has what it takes to provide crucial stimulus to the U.S. economy. However, the presence of debt critics not only in Congress but also among Trump's own cabinet nominees means that implementing this package will probably not be easy. Especially in light of our forecast for a budget deficit for 2017 of 3.5 % of GDP. It would also be the first major fiscal package to be implemented at a time when the United States is almost at full employment and not in a recessionary environment. These are just a few arguments against a further sweeping rise in yields. We will be sure to update our forecasts as the new administration progresses.

Interest income over price appreciation

Our initial approach is not to bet against the current momentum. There were already ample signs of rising interest rates indicating 2016 could be the year of interest-rate lows even before the election. This is also the reason we are expecting the U.S. Federal Reserve to implement another two interest-rate increases in 2017. At the same time, the European Central Bank (ECB) has announced to continue quantitative easing at least until year-end 2017. Spread widening between U.S. and Eurozone bonds should be limited, however, by the growing discussion of ECB tapering as the year progresses and inflation expectations in the Eurzone picking up.

In terms of our investment strategy, we are shortening the portfolio's maturity and focusing on less interest-rate-sensitive securities. We continue to favor high-yield bonds, particularly those from the United States and the Eurozone, as well as emerging-market bonds, although in this category we are more selective. We also continue to favor fixed-income corporate credit from Europe and the United States, which benefit from low default rates, the economic environment and – in the case of European bonds – purchases by the ECB. Peripheral bonds in Europe are interesting again with the recent widening in the spreads. For Europe, especially core European countries, and the United States we see a threat in 2017 coming from negative total returns on government bonds. Only 2-year U.S. Treasuries offer protection from the repercussions of increasing yields. We believe investors will continue to play the reflation theme for a while. We do not, however, expect an end to the low-interest era in the medium term.

Deflation fears have disappeared for government bonds

After Trump's win, investors have turned their focus to the anticipated, debt-financed U.S. fiscal package.

Deflation fears have disappeared for government bonds

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 11/30/16

Fixed-income corporate credit: pay attention to maturities

We continue to see fundamental support for corporate bonds and prefer shorter maturities in the current interest-rate environment.

Fixed-income corporate credit: pay attention to maturities

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 11/30/16

Emerging markets under the spell of the United States

Be it a stronger U.S. dollar, higher U.S. interest rates or protectionist tones – emerging markets may have turbulent times ahead.

Emerging markets under the spell of the United States

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 11/30/16

Forecasts

The end of the era of ultra-low interest rates?

We are positive on investment-grade corporate bonds on both sides of the Atlantic. Although spreads in Europe are again approaching record lows, we believe ECB purchases will continue to support the market and keep volatility to a minimum. We anticipate more volatility in the United States due to the interest-rate environment, but see investors being rewarded with higher yields.

Trump's election has had a noticeable impact on emerging-market bonds. We have raised our spread forecast slightly but remain positive in light of the continually improving fundamentals. Trump's anti-trade rhetoric coupled with rising U.S. interest rates could add some pressure, which we would consider as an opportunity.

  Current* Dec 2017F

United States

U.S. Treasuries (2-year)

1.27%

1.80%

U.S. Treasuries (10-year)

2.60%

3.00%

U.S. Treasuries (30-year)

3.16%

3.65%

U.S. municipal bonds

96%

93%

U.S. investment-grade corporates

120 bp

110 bp

U.S. high-yield corporates

403 bp

450 bp

Securitized: mortgage-backed securities1

89 bp

105 bp

Europe

German Bunds (2-year)

-0.78%

-0.50%

German Bunds (10-year)

0.37%

0.80%

German Bunds (30-year)

1.13%

1.70%

UK Gilts (10-year)

1.49%

1.75%

Euro investment-grade corporates2

128 bp

100 bp

Euro high-yield corporates2

370 bp

375 bp

Securitized: covered bonds

10 bp

10 bp

Italy (10-year)2

146 bp

150 bp

Spain (10-year)2

105 bp

130 bp

Asia-Pacific

Japanese government bonds (2-year)

-0.19%

-0.20%

Japanese government bonds (10-year)

0.09%

0.00%

Asia credit

232 bp

270 bp

Global

Emerging-market sovereigns

339 bp

340 bp

Emerging-market credit

321 bp

350 bp


* Source: Bloomberg Finance L.P.; as of 12/15/16


F refers to our forecasts as of 12/15/16; bp = basis points


1 Current-coupon spread vs. 7-year U.S. Treasuries

2 Spread over German Bunds

Source: Deutsche Asset Management Investment GmbH; as of 12/16/16

Currencies

Will Trump make the dollar great again?

The U.S. dollar profits twofold from Trump's win: One, it is being propelled higher by the expectation that a Republican-dominated Congress could enable the new president to breathe life into the country's lukewarm growth. The slightly more optimistic growth and inflation expectations are already reflected by the rise in longer-term U.S. interest rates. Rates should also rise on the short end, given our expectations that the U.S. Federal Reserve (Fed) will raise interest rates two times in 2017. Such a move would further increase the divergence in monetary policies and interest-rate levels compared to other key regions. The second leg of political support for the dollar could be the hope of a tax-induced repatriation of U.S. assets invested abroad. Resistance to any further appreciation in the dollar, on the other hand, could come from verbal intervention by the Fed or the U.S. Treasury Department. A deterioration in the risk environment, for example, in the form of a sharp correction in the stock market, could also slow down the dollar and strengthen funding currencies such as the euro and the yen. We believe the dollar will remain strong and expect the EUR/USD to reach parity by the end of 2017. Our twelve-month view for the USD/JPY is 120.

Dollar's strength fueled by U.S. interest rates

Will the dollar soon rejoin the "high-interest" currencies of the G10?

Dollar's strength fueled by U.S. interest rates

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 11/4/16

Dollar strength and pound weakness

We believe that both the British pound and the Chinese renminbi will remain weak.

  Currencies Current* Dec 2017F

EUR vs. USD

1.04

1.00

USD vs. JPY

118.18

120.00

EUR vs. GBP

0.84

0.847

GBP vs. USD

1.24

1.18

USD vs. CNY

6.95

7.30

*Source: Bloomberg Finance L.P.; as of 12/15/16

F refers to our forecasts as of 12/15/16.

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