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
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- 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 , visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.