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by  D.Mitchell, CFA, D.Fijalkowski, MBA, CFA Mar 15, 2023

Dagmara Fijalkowski, Head of Global Fixed Income & Currencies, explores the outlook for fixed income for the balance of the year following an unusually volatile first quarter. Dan Mitchell, Senior Portfolio Manager, provides an outlook for the U.S. dollar, and whether this is the start of a long-term decline in the greenback.

Watch time: 5 minutes 31 seconds

View transcript

What is the outlook for fixed income markets for 2023?

We have seen a lot of crazy volatility in fixed income markets in recent weeks. At times like this, we find it helpful to look at history to help organize our efforts. We did, and we have made four important observations.

First, is that expected real policy rates are attractive. They are north of 1.5% and historically rates like that have preceded positive returns on bond portfolios. If you think even about two-year bonds, and look at where they are trading now, yields would have to double from these levels before investors start losing money on this investment.

Second, in the past 150 years, we have not seen three consecutive years of negative returns on 10-year Treasury notes. We have had two negative years, 2021 and 2022. So the odds of 2023 being a negative year are very low.

Third, historically, bonds have positive returns in six months heading into our last hike by the Fed, and 12 months following the last hike. Now, we may not know exactly where and when terminal rate is going to happen, but we have high confidence that we are within six months before the last hike by the Fed.

Finally, the beginning of the recession is near. We believe that the point of maximum curve inversion is behind us. And with the market expecting Fed cuts over the next two years, the curve is going into the shape of bullish steepening. And bullish steepening historically is an environment when investors benefit from being invested in sovereign bonds and long duration.

All of the above balance in favour of fixed income investments. There is only one scenario that tells us to avoid bonds. That's the bearish curve steepening scenario. That's something that's similar to the environment repeat of the seventies, when central banks, as I say it, lost the plot. We know it and the Fed knows it. And we can be certain that the Fed has studied seventies at length to avoid making similar mistakes.

When it comes to making a choice between protecting short-term growth and defeating inflation, we can be sure that the Fed is going to choose to defeat inflation because that's the only way in which they can protect long-term growth.

Taking all of these on bonds, we believe 2023 is more likely to see positive returns from fixed income.

What's the outlook for the U.S. dollar for 2023?

We've seen a bit of a bounce in the U.S. dollar so far this year, mostly in February and early March. The greenback's up about two and a half percent since the start of 2023, but still about 7 or 8% lower on a trade-weighted basis than it was last October at its highs. At that time, it was really all about interest rates. The Fed was hiking in 75 basis-point increments and the market didn't have a great sense for when or where they would stop. And so even though now that the Fed is still raising rates, they're doing so in a much slower fashion and the market has a good sense that we're near the end of that hiking cycle.

Importantly, it's not just what happens in the United States, but also what happens abroad that's important for foreign exchange markets. And we've seen a couple of important international developments that have increased the appeal of holding foreign assets. It really is an investment destination. Among those are the Chinese reopening, which offers a bit of a growth bump to the rest of the world. We have better economic prospects in Europe, thanks to lower gas prices and a milder winter. And we have hawkish central banks abroad, including in Europe and Japan, that will help limit the U.S. interest rate advantage.

Has the long-term decline in the U.S. dollar begun?

This U.S. dollar bounce that we've seen over the past couple of months we think is temporary. In fact, we think the highs from last October marked the very beginning of a long-term cyclical decline in the U.S. dollar that will see it fall by about 30 or 40% over the next couple of years.

That's a pretty significant move for the currency markets. And because the U.S. dollar is such an important force for foreign exchange markets as a whole, we're likely to see all other currencies, including emerging and developed market currencies, benefit from that dollar decline.

Our own forecasts at RBC GAM imply that the euro, the Japanese yen and the Canadian dollar will all rally by more than 10% this year.

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Publication date: March 15, 2023