Monetary Tightening and Inflation Could Wake the Bond Bears
The Federal Reserve’s program to shrink its balance sheet will likely push bond yields higher as the market will need to absorb more supply.
Inflation is likely to rise. Stronger economic growth globally, a tight labor market and tax cuts point to a potential pickup in inflation in 2018.
Markets appear complacent. With rates low, the yield curve relatively flat and credit spreads very narrow, fixed income markets aren’t priced for higher inflation or volatility.
Returns in fixed income are likely to be driven by the income generated rather than price appreciation.
Are the bond bears finally ready to wake from their slumber? It's looking likely. The combination of tighter monetary policy and inflation pressure stemming from stronger economic growth could weigh on bond prices. As a result, 10-year Treasury yields could climb to their highest levels in more than three years in 2018.
With valuations in most fixed income asset classes quite high, we don't think markets are currently providing much compensation to investors for the possibility of increased volatility.
However, some perspective is in order. While conditions look favorable to the bears, we expect the overall rise in yields to be fairly moderate. Returns will likely continue to be positive, though most of that return will be in the form of interest income, rather than price gains.
It's also worth keeping in mind that bond bear markets are generally much milder than bear markets in stocks. Over the past 40 years, there have only been a handful of years when the Bloomberg Barclays U.S. Aggregate Bond Index generated losses. Even then, the losses tended to be modest compared to bear markets in stocks. For example, when the Fed nearly doubled the federal funds rate over the course of 1994, the index suffered a loss of just 3.0%. Moreover, even in the bear market that stretched from 1954 to 1981, negative annual returns were infrequent. That’s because the income payments from the bonds offset some of the price decline.
Here we’ll look at some of the factors that could lead to volatility this year and offer some suggestions about how investors should prepare.
Central bank policies are getting tighter
The era of extremely easy money is coming to an end. While the Federal Reserve has been raising short-term interest rates since late 2015, policy really hasn’t been “tight” by historical standards because until recently, short-term rates were still lower than the rate of inflation.
In 2018, we expect three rate increases of a quarter percentage point each, which would mean real short-term interest rates would be positive for the first time in nearly a decade. In general, rising rates could be a drag on prices, which could help push yields higher.
“Real” three-month Treasury bill yields
Note: A real interest rates is an interest rate that has been adjusted to remove the effects of inflation.
Source: Bloomberg. U.S. real three-month treasuries. Monthly data as of 1/12/18. Last data point is based on the December 2017 CPI reading.
But that’s not all. The Fed is also in the process of scaling back its bond holdings—the central bank has indicated it would like to shrink its balance sheet by $400 billion this year. That is also likely to drive yields higher.
Some of these bonds are mortgage-backed securities and the rest are treasuries that the Fed accumulated during its three rounds of quantitative easing after the financial crisis of 2008-2009. Without the Fed buying up as many bonds to replace its maturing securities, the market will need to finance a larger proportion of the ever-increasing federal debt. Because private investors tend to be more yield sensitive than central banks, we expect yields will need to rise to attract buyers.
Other central banks are also cutting back on bond buying. The European Central Bank (ECB) is planning to gradually reduce its bond buying program this year and will probably end it by September. The Bank of Japan (BOJ) is still expanding its holdings, but has decreased its bond purchases in favor of direct targeting of interest rates.
Quantitative easing programs and low-to-negative interest rate policies were major factors holding down interest rates over the past decade. The withdrawal of these measures, even at a very gradual pace, should mean that interest rates rise in both nominal and real terms over the next few years.
Total assets of major central banks
Source: Federal Reserve Board, European Central Bank and Bank of Japan. Data as of 1/5/18.
Inflation is likely to rise
Every year seems to start with economists predicting higher inflation, only to have inflation do a disappearing act. That looks set to change. We think the chances of a pickup in inflation are higher in 2018 than they have been for quite some time. Inflation erodes the value of bonds because fixed coupon payments have less buying power.
One reason to expect higher inflation is purely technical. Compared to a year ago, prices don’t need to rise much for there to be a year-over-year increase. That’s because a sharp drop in cell phone plan costs and a handful of other items last year helped drive a dip in the Consumer Price Index (CPI). All prices need to do is hold steady this year for the inflation reading to tick up.
CPI and core CPI
Note: The Consumer Price Index measures changes in the price level of consumer goods and services purchased by households. Core inflation (Core CPI) is a measure of inflation which excludes certain items that face volatile price movements, notably food and energy.
Source: Federal Reserve Bank of St. Louis. Consumer Price Index for All Urban Consumers: All Items Less Food & Energy (Core CPI) and Consumer Price Index for All Urban Consumers: All Items, Percent Change from Year Ago, Monthly, Seasonally Adjusted. Data as of 12/2017.
Beyond the technical factors, it’s possible higher wages could support stronger consumer spending, which could help push inflation higher. Job growth has been strong and the unemployment rate is falling, which should push up wages. There are already signs wages are rising for some professions and in regions where the economy is strong. The Atlanta Federal Reserve’s wage tracker index shows companies have been increasing pay at a 3.3% rate for employees with more than a year’s tenure due to strong demand for higher skilled and experienced workers.
The trend is likely to become broader-based as the supply of workers relative to demand diminishes. In addition, tax cuts will be showing up in paychecks in 2018 thanks to the recent legislative changes, fueling stronger consumer spending.
Global growth prospects are looking up
The global backdrop for growth and inflation also suggests interest rates could move higher. This year could be the first year in a decade in which all of the world’s major economies grow at the same time. As economic activity picks up, excess capacity will be absorbed, easing the deflation risks that have been a cause of low bond yields since the recession. The International Monetary Fund (IMF) estimates that the output gap (difference between potential and actual growth) has closed for the first time in a decade. As the global economy returns to a more normal balance, interest rates are likely to follow.
Output gaps among G-7 countries have closed
Source: International Monetary Fund, World Economic Outlook Database, 10/2017. Note: Major advanced economies (G-7).
Bond markets are highly valued
In the face of all these potential sources of volatility, fixed income investors also must contend with the fact that much of the market looks expensive relative to long-term average valuations. Yields in the corporate and municipal bond markets are low compared to Treasury yields, providing little reward for the added risk. With such a positive economic outlook, we don’t anticipate a major increase in yield spreads, but there simply isn’t much room for further narrowing. Because risks rise as credit quality declines, we are most cautious about lower credit quality bonds such as high-yield corporate bonds.
Moreover, tax law changes will limit the amount of interest expense that companies can deduct from their tax liabilities. Consequently, companies with high debt loads and low or no earnings could be adversely affected. See 2018 Credit Outlook: Curb Your Enthusiasm.
Relative yields for most fixed income investments are well below their long-term averages
Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. Municipal spread is the 10-year municipals-over-bonds (MOB) spread. The MOB spread is the yield on an index of AAA-rated muni bonds as a percent of the yield on a Treasury bond before considering taxes.
Source: Bloomberg Barclays and Bloomberg. Indexes representing the investment types are: Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High Yield), Bloomberg Barclays Emerging Market USD Aggregate Index (Emerging Market USD Aggregate), Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade), and the BofA Merrill Lynch Fixed Rate Preferred Securities Index (Preferred Securities), BVAL Municipal AAA Yield Curve 10 Year (Municipal Bonds). Data as of 1/16/2018.
The outlook for the municipal bond market is brighter. Although valuations for short-term munis appear high, intermediate-to-long term munis look more reasonably priced. Credit quality remains high in most of the municipal bond market and we don’t think the new tax law is likely to affect the supply/demand balance.
International and emerging market bonds, which performed quite well last year thanks to a falling dollar and ongoing low yields, are likely to be more challenging investments this year. Among developed market countries, tighter central bank policies could mean price declines for low or negative yielding short-term bonds. Meanwhile, longer-term bond yields are still low relative to Treasury bond yields, reducing the potential for returns in a rising interest rate world.
Emerging market bond yields are at record lows relative to Treasury yields at a time when EM debt levels have soared. Much of the debt is denominated in either U.S. dollars or euros, which leaves the market vulnerable to tighter central bank policies. With the risk/reward unattractive, we suggest underweighting EM bonds.
The spread between EM bonds and Treasuries has been narrowing
Note: OAS is a method used in calculating the relative value of a fixed-incomes security containing an embedded option, such as a borrower's option to prepay a loan.
Source: Bloomberg Barclays EM USD Aggregate Bond Index as of 1/12/2018.
What to do
How should investors think about their bond portfolios as they enter the new year? We would say be cautious. Investors should consider keeping their average portfolio duration in the short-to-intermediate area of the yield curve in anticipation of higher interest rates later this year. They should also focus on higher credit quality bonds to avoid the risk of increased volatility.
As we mentioned above, high valuations could take further price gains off the table, so investors should expect most of their returns to come from the income generated rather than capital gains.
That said, we also see an opportunity for investors to capture more income with potentially less risk as market values move back to more normal levels. With a strategy designed to take advantage of rising bond yields, such as a bond ladder, investors can get the most out of a modest bear market.
Investors have been waiting a long time for yields on lower-risk fixed income investments such as Treasuries and investment grade bonds to rise. We believe 2018 could be the year when rising bond yields could be a positive for 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.
Explore Schwab’s views on additional fixed income topics in Bond Insights.