Past the peak of central bank stimulus: Led by the Federal Reserve, major central banks are poised to reduce the amount of monetary stimulus flowing to the global economy. Deflation fears are easing, with interest rates slowly moving out of negative territory in Europe and Japan, a trend we expect to continue in 2018.
Potential inflation surprise: Stronger economic growth, a tight labor market and the prospect of tax cuts could mean that inflation in the U.S. hits or exceeds the Federal Reserve’s 2% target in 2018.
Markets appear complacent: With rates low, a flattening yield curve and tight credit spreads, fixed income markets aren’t priced for higher inflation or volatility.
Central bank tightening may awaken bond bears
2018 could be the year that bond bears finally awaken from their long slumber, sending 10-year Treasury bond yields above the three-year high of 2.6%. Economic growth is picking up both globally and domestically and fiscal policy is becoming more expansive. Most importantly, the era of extremely easy money is coming to an end. The Federal Reserve is tightening monetary policy through rate hikes and balance sheet reduction. The European Central Bank (ECB) is planning to gradually reduce its bond buying program. Even the Bank of Japan (BOJ) is seeing some success with positive inflation while focusing on keeping 10-year bond yields at zero or above. As the easy-money era gradually recedes, we see more upside risk in yields than downside.
Bond bears awakening
Bond markets are highly valued
Most segments of the fixed income markets appear 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 added risk. With the economic outlook positive, we don’t anticipate a major increase in yield spreads, but there simply isn’t much room for further narrowing. Since risks rise as credit quality declines, we are most cautious about lower credit quality bonds—like high-yield corporate bonds. 2018 could be a year when the income generated by bonds is the major source of return rather than price appreciation.
With markets priced for ongoing moderate growth and low volatility, the risks we are monitoring include the potential for more central bank tightening than expected and the potential for fiscal stimulus from tax reform.
- Short-to-intermediate duration: For Treasuries and investment grade bonds, we suggest keeping duration in the 3-7 year range to mitigate the risks of rising rates. Investment grade floating-rate notes should benefit from further Federal Reserve tightening.
- Stay up in quality: Corporate bond credit spreads are near the post-crisis lows and well below their long-term averages, offering little compensation for their additional risks. Even a modest rise in the yield spread—likely due to increased volatility—could result in disappointing returns for lower-rated bonds.
- International: Low yields and the potential for tighter monetary policy make international and emerging market bonds less attractive.
- Municipal bonds: Valuations are high for short-term maturities but near long-term averages for longer maturities. Credit quality remains high in general. Five- to eight-year durations offer better risk/return characteristics.