Bond investors generally have been preparing for stronger economic growth in 2017, due to fiscal and regulatory policy changes on the horizon. That typically means bond yields should rise.
But lacking specific plans from the White House and Congress, the rise in yields has been limited by an economy still stuck in first gear, says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research.
“It looks like the bumpy ride for bond investors may continue a while longer,” Kathy says.
Some recent economic data suggest that bond yields could move lower, Kathy says. For one thing, inflation recently has appeared to have stalled at the 2% level¹, she says. Meanwhile, gross domestic product (GDP) growth slowed markedly in the first quarter—to an annualized pace of 0.7%, the weakest growth in three years and well below the long-term trend of 2%.
But other data is more positive: Surging consumer and business confidence have boosted investment in housing and capital equipment, supporting prospects for a rebound in growth in the next few quarters.
GDP slowdown: Will it last?
Many have dismissed the GDP slowdown in the first quarter of 2017 as a seasonal quirk. It has happened in previous first quarters, but been followed by stronger GDP growth in the second quarter. However, it might be a mistake to anticipate a sharp rebound in the second quarter this time around, she says. That’s because last quarter’s drop was not primarily driven by inventory decline, but by a sharp slowdown in consumer spending, especially on durable goods like autos and appliances.
“As many have noted lately, this is at odds with the soaring readings of consumer confidence over the quarter,” Kathy says. “If the gap between sentiment and spending persist, 10-year Treasury bond yields could remain in the 2.20% to 2.35% range for a while.”
Watching the Fed
Federal Reserve policymakers are set to meet May 2-3 to discuss interest rate policy. The Fed has raised short-term interest rates twice in the past six months, most recently in March. At the time, the Fed’s quarterly economic projections suggested policymakers anticipated two more quarter-percentage-point rate hikes in 2017, bringing the federal funds target range to between 1.25% and 1.5% by year end.
In coming months, investors will be closely watching the areas the Fed monitors, including inflation, job and wage growth, to determine whether that plan remains on track. Although the March employment report was disappointing, the underlying trends in the labor market have been positive, Kathy notes.
“For the Federal Reserve, even modest job growth is enough to keep it in tightening mode if it’s coupled with rising wages,” Kathy says. “While wage growth of 2.7% year over year is hardly robust, it’s far better than it was two years ago, and it is above the rate of inflation. So barring a surprising downshift in the economy, the Fed is likely to keep gently tapping on the brakes over the next few quarters.”
Tips for bond investors
Even though long-term yields have declined so far this year, Kathy continues to suggest caution toward longer-term bonds. “The risk to an upside surprise in Fed policy and/or economic data doesn’t warrant taking a lot of duration risk at this time, in our view,” she says.
Instead, she suggests keeping average “duration” of your fixed income portfolio in the short-to- intermediate term—for instance, between three years to five years—and focusing on high-quality “core” bonds, such as domestic investment-grade corporate and municipal bonds along with Treasury securities and certificates of deposit. These types of bonds are typically less volatile than longer-term or lower-credit-quality bonds, like high yield bonds or emerging market bonds.
Investors might also consider investment-grade floating-rate notes and/or intermediate to long maturity Treasury Inflation Protected Securities (TIPS). Floaters, which have very short durations and whose income paid is linked to short-term rates, may benefit from additional Fed rate hikes. Meanwhile, TIPS with intermediate to longer-term maturities may help reduce volatility if inflation rises, Kathy says.
¹ Consumer Price Index for all items less food and energy, based on the March 2017 report from the Bureau of Labor Statistics, published 4/14/2017.
What you can do next
- 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.
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