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Fed Policy Is Back to Neutral—Now What?

Key Points
  • The Federal Reserve paused rate hikes at the “neutral” level and fixed income prices rallied.

  • However, after strong first-quarter performance, fixed income asset returns are likely to be modest.

  • We’ll discuss how to invest in the current rate environment.

Fed policy in neutral

The Federal Reserve’s decision to halt its interest rate increases helped propel markets higher in the first quarter. Declaring that the policy rate had hit “neutral,” and worried that the economy was facing potential disruptions from the government shutdown and slowing growth abroad, the Fed decided to hit the pause button.

The “neutral” rate, according to the Fed, is the policy rate that is neither so high that it slows the economy nor so low that it allows the economy to grow too fast and push up inflation. The Fed’s estimate of the neutral rate for the federal funds rate has been in the 2.5%-to-3.0% range for the past few years. At 2.25% to 2.5%, the federal funds rate is near the lower end of that estimate.

The Fed also announced that it would end the reduction in its balance sheet later this year, leaving its bond holdings at a higher level than previously anticipated. These moves have tilted policy to the easier side.

The Fed’s balance sheet reduction will likely end with total assets near $3.5 trillion, higher than previously indicated

Source: Federal Reserve Bank of New York and the Board of Governors of the Federal Reserve, using data as of 3/31/2019.

Financial asset prices have rallied sharply since the Fed pause, relieved that further tightening in monetary policy would be unlikely any time soon. Every segment of the fixed income markets we follow produced strong returns in the first quarter. The best performance came from assets with the most exposure to risk—both interest rate risk and credit risk. For example, returns for high-yield corporate bonds and preferred securities were 8.1% and 8.7%, respectively. The strong returns underscore the benefit of holding a variety of fixed income assets.

Fixed income assets produced strong returns in the first quarter

Source: Bloomberg, as of 03/31/2019. Past performance is no guarantee of future results.

Note: Asset classes are represented by the following indexes: US Aggregate: Bloomberg Barclays U.S. Aggregate Bond Total Return Index; Short-term core: Bloomberg Barclays U.S. Aggregate 1-3 Years Bond Total Return Index; Intermediate-term core: Bloomberg Barclays U.S. Aggregate 5-7 Years Bond Total Return Index; Long-term core: Bloomberg Barclays U.S. Aggregate 10+ Years Bond Total Return Index; Treasuries: Bloomberg Barclays U.S. Treasury Index; TIPS: Bloomberg Barclays U.S. Treasury TIPS Total Return Index; Agencies: Bloomberg Barclays U.S. Agency Bond Total Return Index; Securitized: Bloomberg Barclays U.S. Securitized Bond Total Return Index; Municipals: Bloomberg Barclays Municipal Bond Total Return Index; IG Corporates: Bloomberg Barclays Corporate Bond Total Return Index; HY Corporates: Bloomberg Barclays U.S. High Yield VLI Total Return Index; IG floaters: Bloomberg Barclays US Floating Rate Notes Total Return Index; Bank loans: The S&P/LSTA U.S. Leveraged Loan 100 Index; Preferreds: Merrill Lynch BofA Preferred Stock Total Return Index; Int. developed (x-USD): Bloomberg Barclays Int'l Developed Bonds (x-USD) Total Return Index; EM: Bloomberg Barclays Emerging Market Bond (USD) Total Return Index.

However, given the sharp rally in bond prices and concurrent drop in yields, a repeat of Q1 performance appears unlikely. Returns to date have been on par with the gains that are often seen over the course of an entire year. Valuations now reflect the expectation that the Fed will not only keep short-term rates on hold, but will actually lower them later in the year—a possibility that may not happen. Nevertheless, we do expect returns to continue to be positive and in line with the coupon income generated by holding bonds.

What to watch

We also believe that there is a strong possibility that the Fed’s next move will be a rate cut rather than a hike, but this will depend on how the economy and inflation perform, and at any rate likely would not happen until later in the year.

In order to assess the likelihood of a cut, we looked at past interest rate cycles to see what indicators were helpful in anticipating an easing in Fed policy. We found that most easing cycles were preceded by a drop in the ISM Manufacturing index to below 50, a slowdown in payroll growth, a flat or inverted yield curve and/or a deterioration in financial conditions.

Selected indicators to watch

Source: Bloomberg (ISM Manufacturing PMI SA: NAPMPMI Index; Financial Conditions:  BFCIUS Index; Nonfarm Payrolls YoY%: NFP TYOY; 10-year & federal funds spread: LEI IRTE Index). Gray bars indicate the first rate cut in past easing cycles. Monthly data as of March 2019.

So far, the yield curve inverted briefly and payroll growth has slowed, but neither indicator is sending a strong signal that the Fed is likely to cut rates soon. It’s worth noting that while the majority of rate easing cycles were driven by economic weakness, a few (in 1987 and 2007) were initiated in response to signs of stress in the financial markets. Also, U.S. Treasuries are traded and held globally, which makes comparative yields important. U.S. Treasury yields are high compared with the government bond yields of most other major developed countries. Therefore, U.S. bond yields are likely to be held down by demand from global investors searching for government bonds yielding more than zero.

U.S. yields are higher than most other major developed countries’ yields

Source: Bloomberg. Data as of 4/15/2019. Past performance is no guarantee of future results.

Investing in a neutral market

Meanwhile, the bond market looks more reasonably priced now than it was late last year. Based on Bloomberg’s fair-value model estimates, 10-year Treasury yields near 2.6% are fairly valued. The model takes into account the expected path of Fed policy, inflation and the trend in employment. We anticipate that slowing growth and easing inflation will mean that the Fed keeps policy on hold this year and yields in a range of about 2.25% to 2.75%.

Since the yield curve is partially inverted, with two- to five-year Treasury yields lower than one-year yields, we suggest investors consider barbells—that is, holding some short-term bonds (one- to three-year maturities) along with some intermediate-term bonds (about seven years).

Intermediate-term yields are now lower than both short-term and long-term yields

Source: Bloomberg, data as of 4/15/2019. Past performance is no guarantee of future results.

In a market where Fed policy is in neutral and bonds seem reasonably priced, times when yields diverge substantially may offer tactical opportunities to increase or decrease allocations. However, for longer term investors, we suggest holding a well-diversified portfolio of fixed income assets that can deliver income in a low-yield environment. We suggest aiming at higher-credit-quality bonds due to the potential for a slowdown in economic growth down the road.

What You Can Do Next

  • Follow Kathy Jones (@KathyJones) on Twitter.
  • 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.
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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.  Investing in emerging markets may accentuate these risks.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US Government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

Preferred securities: (1) Generally have lower credit ratings than the firm's individual bonds (2) They generally have a lower claim to assets than the firm's individual bonds (3) Often have higher yields than the firm's individual bonds due to these risk characteristics. (4) Are often callable, meaning the issuing company may redeem the securities at a certain price after a certain date.

The Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more. The 1-3 year, 5-7 year, and 10+ year indexes are all components of the broad U.S. Aggregate Bond Index.

The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

The Bloomberg Barclays U.S. Agency Bond Index includes securities issued by US government owned or government sponsored entities, and debt explicitly guaranteed by the US government). It is a component of the Bloomberg Barclays U.S. Government Bond Index.

The Bloomberg Barclays U.S. Securitized Bond Total Return Index is part of the broad Bloomberg Barclays U.S. Aggregate Bond Index and is designed to capture fixed income instruments whose payments are backed or directly derived from a pool of assets that is protected or ring-fenced from the credit of a particular issuer (either by bankruptcy remote special purpose vehicle or bond covenant). Underlying collateral for securitized bonds can include residential mortgages, commercial mortgages, public sector loans, auto loans or credit card payments. There are four main subcomponents of the securitized sector: MBS Pass-Through, ABS, CMBS and Covered.

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.

The Bloomberg Barclays Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.

The Bloomberg Barclays U.S. High-Yield Very Liquid (VLI) Index measures the market of U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt. The U.S. Corporate High-Yield Index was created in 1986, with history backfilled to July 1, 1983, and rolls up into the Barclays U.S. Universal and Global High-Yield Indices.

The Bloomberg Barclays U.S. Floating-Rate Notes Index measures the performance of investment-grade floating-rate notes across corporate and government-related sectors.

The S&P/LSTA U.S. Leveraged Loan 100 Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market. The index consists of 100 loan facilities drawn from a larger benchmark - the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).

The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate USD-denominated preferred securities issued in the U.S. domestic market.

The Bloomberg Barclays Global Aggregate ex USD Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The two major components of this index are the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices.

The Bloomberg Barclays Emerging Markets USD Aggregate Bond Index includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The ISM Manufacturing index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

The Bloomberg U.S. Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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