2018 Mid-Year Bond Outlook: Last One Out, Turn Off the Lights
As central banks move toward tighter monetary policy, global liquidity is declining for the first time in nearly a decade. This is leading to higher volatility, especially in the riskier segments of the fixed income market.
Long-term yields may be nearing a cyclical peak near 3%. Bond yields and the federal funds rate historically have peaked near the same level.
The yield curve will likely continue to flatten. We expect one to two rate hikes by the Federal Reserve in the second half of the year, but short-term rates will likely rise more than long-term interest rates.
Investors should be able to find higher yields with less risk.
It’s getting later
The current economic expansion is now officially the second-longest in the post-WWII era. While we don’t see a recession on the horizon any time soon, we do believe that the U.S. has entered a late stage of this long business cycle. The late-cycle phase presents both opportunities and risks for fixed income investors. It is often a time of rising volatility, as bond prices adjust to tighter monetary policy and excesses built up during the expansion, but it also provides investors the opportunity to invest for more income without as much risk.
The era of easy money has ended
With central banks retreating from the extraordinary policies put in place after the financial crisis, the amount of excess global liquidity is likely to shrink. That extra liquidity was a key factor holding down volatility and risk premia. As the process unwinds, we see the potential for a much more volatile stretch ahead of us.
Although the Federal Reserve began raising short-term interest rates in December 2015, the pace of tightening in this cycle has been exceptionally slow compared to past cycles. Of the past three cycles, the longest was 25 months. The current cycle has already exceeded it by six months and looks likely to continue for another year or more. Moreover, this cycle was characterized by near-zero interest rates for many years and a massive increase in the Fed’s balance sheet. In moving to tighter policy, the Fed’s primary goal has been to “normalize” rates—to unwind these extraordinarily easy policies put in place after the financial crisis. Consequently, interest rate risk was the most significant challenge for the bond market, with longer-duration bonds declining in value relative to shorter-term bonds.
Tightening is getting real
However, the Fed’s monetary policy stance reached an important turning point recently. The pace of rate hikes has stepped up and for the first time in several years, short-term interest rates in the U.S. are above the rate of inflation. The two-year Treasury note yield was 2.55%, as of June 22, compared with the core inflation rate of 1.8% through the end of April. Policy has moved from easy to neutral and is now entering the “real” tightening stage.
Real short-term rates are in positive territory
Source: 2-year Treasuries minus personal consumption expenditures excluding food and energy (chain-type price index), percent change from year ago, seasonally adjusted. Monthly data as of 6/22/2018.
Moreover, the Fed’s balance sheet has begun to shrink for the first time in a decade. It’s still quite large at $4.3 trillion, but based on the Fed’s projections, the pace of decline has accelerated. As the Fed pulls back on reinvesting the principal of the maturing bonds on its balance sheet, the market will need to absorb more of the bonds issued by the Treasury. The Fed was indifferent to the yield on the bonds it was buying, but investors in the broader market may demand a higher yield to absorb the increased supply.
The Fed isn’t the only central bank exiting its bond buying program. The European Central Bank recently indicated it would phase out bond purchases at the end of the year and aim to hike short-term interest rates in 2019. The Bank of Japan is still pursuing very easy monetary policy, but with inflation creeping higher and the supply of bonds to buy limited, its quantitative easing program is likely to be less significant going forward.
Major central banks’ balance sheets are projected to shrink
Source: U.S. Federal Reserve (Fed), Bank of Japan (BOJ) and European Central Bank (ECB) projections. Data as of 1/30/18.
However, it looks like the risk of higher interest rates has largely been priced into the U.S. bond markets. At about 3%, the 10-year Treasury yield reflects further tightening by the Fed. The most recent set of economic projections released by the Fed on June 13th indicated a median estimate of 3.4% for the peak of the federal funds rate for this cycle and a longer-run estimate of 2.9%.
Since long-term yields are the weighted average of short-term yields plus a risk premium, in most cycles, 10-year Treasury yields have peaked near the peak level for the federal funds rate.
In past tightening cycles, 10-year bond yields and the federal funds rate have peaked around the same level
Source: Effective federal funds rate (FEDFUNDS) and 10-Year Treasury constant maturity rate, percent, monthly, not seasonally adjusted (DGS10). Data as of 6/21/2018.
(The 1994 tightening cycle was an outlier to this pattern. The Fed hiked rates much more aggressively than anticipated, causing bond yields to overshoot.)
Yield curve flattening is also a sign that the cycle is getting long in the tooth. The spread between 2-year and 10-year Treasury bonds has fallen to less than 50 basis points, its lowest level since 2007. The narrowing in the yield spread is a normal development when the Fed is tightening, as tighter policy signals slower growth and less inflation pressure longer-term. Based on market indicators, inflation expectations are consistent with the Fed’s target of 2% inflation longer-term.
The gap between short- and long-term rates is near a post-recession low
Note: The rates are comprised of Market Matrix U.S. Generic spread rates (USYC2Y10). This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100.
Source: Bloomberg. Daily data as of 6/21/2018.
Given the narrowness of the spread between short and long-term rates, there is a risk that the yield curve could invert if the Fed is more aggressive in raising interest rates than current projections suggest. Inverted yield curves have preceded recessions in the past, although the time lags between an inversion and recession can be long and vary greatly. Nonetheless, the Fed may decide to slow the pace of rate hikes over the next year if the yield curve continues to flatten. We expect two more rate hikes in 2018 and at least two more in 2019, which would bring the federal funds rate to the 2.75% to 3.0% region, consistent with the Fed’s estimates.
Credit risk comes into focus
Late in the business cycle, credit risk—that is, the risk that bond issuers will default on their debt—can become more prominent. As monetary policy tightens, the cost of credit rises, and eventually lending standards tighten and over-leveraged borrowers, whether individuals, companies or countries, may default on their debts. So far in this cycle, the cost of credit has risen but the availability hasn’t declined. However, there are early signs of risk aversion in the markets. The recent downdraft in emerging-market bonds and currencies may be another signal that it’s late in the cycle. EM bond prices have fallen steeply since the beginning of the year, in both U.S. dollar and local currency terms. Tighter Fed policy is reducing the excess liquidity in the global markets and the value of the dollar has been rising, a negative combination for EM bonds.
We have favored keeping the average duration in portfolios in the short-to-intermediate range to mitigate the negative impact of rising rates. Now that longer-term yields have reached 3%, we’ve debated suggesting investors start to add some duration to portfolios. However, we aren’t quite ready to make that call. The economy is growing at a healthy pace and inflation expectations, which are central to bond yields, are still rising. In addition, the Treasury’s borrowing needs are rising due to the tax and spending bills passed earlier in the year, while the Fed is simultaneously reducing its buying, leaving more to be financed in the market.
Until there are signs of slower growth or rising risk aversion, we continue to favor maintaining average portfolio duration in the short to intermediate term, but we’re getting closer to a stage in the business cycle where modestly extending the average duration will begin to look more attractive. For now, the risk/reward trade-off in the yield curve looks most attractive in the two- to five-year range.
Duration doesn’t pay – yet
Source: Bloomberg as of 6/22/2018.
We suggest investors should be very selective about the credit risks they take. It’s typical that in the late stages of the business cycle, excesses have built up in the markets and credit quality may deteriorate. (We will be publishing our outlook on corporate bonds in the next few weeks.)
We continue to favor maintaining an underweight to emerging market bonds due to the impact of Fed tightening, a firmer dollar and below-average valuations.
Getting more for less risk
As the economic cycle progresses, fixed income investors can benefit from the tightening in Fed policy. With short-term Treasury yields moving higher, there is less need to stretch for yield than during the era of easy money. Today investors can earn higher yields than in the recent past, with relatively low interest rate risk and credit risk. Positive real yields and re-pricing of risk to more sensible levels should offer investors the chance to get better risk-adjusted returns going forward. We believe that opportunity is unfolding and will improve in the second half of the year. It won’t likely be an easy transition, but a return to more attractive valuations should benefit long-term investors.
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
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