Advisor Services

To expand the menu panel use the down arrow key. Use Tab to navigate through submenu items.

2019 Market Outlook: Fixed Income

By
December 05, 2018

Member for

2 years 1 month
a00000
Submitted by Site Factory admin on Wed, 12/05/2018 - 10:21

Ten-year Treasury yields may have peaked for this cycle at 3.25%. Tighter central bank monetary policy, a strong dollar and weaker global growth may dampen growth and inflation prospects in 2019, limiting the rise in bond yields.

The Fed may pause or end federal funds rate hikes by mid-2019, near 3%, if the yield curve flattens and inflation remains tame.

Volatility likely will continue as markets adjust to the end of the easy-money era.

We expect the dollar to stay firm until there is evidence that the Fed is done tightening and/or global growth picks up.

Peak expectations

The worst may be over for the bond bear market. After more than two years of steadily rising bond yields (and falling bond prices, which move inversely to yields), our research suggests that 10-year Treasury bond yields may have peaked for this tightening cycle at the 3.25% level. The Federal Reserve likely will continue to raise short-term interest rates to about 3% in 2019, but we don’t see longer-term yields moving much above the recent highs. Tighter global monetary policy, a strong U.S. dollar and sluggish global growth exacerbated by trade conflicts are likely to weigh on economic growth and inflation, limiting the rise in bond yields.

However, the path forward isn’t likely to be smooth. As markets adjust to tightening financial conditions, volatility is likely to increase.

It’s stormy at the top

We expect the Federal Reserve to raise rates two to three more times, bringing the federal funds target rate to the 2.75% to 3% area in early 2019, short of  the Federal Open Market Committee’s 3.4% median estimate for 2020.¹ Because short- and long-term interest rates tend to converge at cycle peaks, the yield curve likely will flatten toward zero. We suggest investors gradually add to average portfolio duration when yields rise.

As the Fed normalizes rates and reduces its balance sheet, volatility may increase in riskier parts of the fixed income market—such as bank loans, high-yield and emerging-market bonds—due to issuers’ high leverage. We suggest investors move up in credit quality and/or limit exposure to these asset classes. Municipal bonds may post solid performance in 2019, as demand appears strong for tax-exempt income.

The 10-year Treasury yield and the federal funds rate both peaked around 9.6% in 1989, around 6.5% in 2000, and around 5.25% in 2006.

Takeaways

  • Consider adding to portfolio duration as bond yields rise, in order to capture more income, as the business cycle advances.
  • Consider moving up in corporate credit quality. Corporate bond market risks are rising, but the additional “yield premium” that both investment-grade and high-yield corporate bonds offer versus Treasuries remains relatively low.
  • Consider higher-rated municipal bonds, in the five- to eight-year part of the yield curve. Although muni credit quality is generally strong (albeit with pockets of risk), tight credit spreads don’t justify taking on additional credit risk.

 

¹Based on the FOMC Summary of Economic Projections, 09/26/2018