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2019 Market Outlook: Fixed Income

Key Points
  • Ten-year Treasury yields may have peaked for this cycle at 3.25%. Tighter central bank monetary policy, a strong dollar and weaker global growth may dampen growth and inflation prospects in 2019, limiting the rise in bond yields.

  • The Fed may pause or end federal funds rate hikes by mid-2019, near 3%, if the yield curve flattens and inflation remains tame.

  • Volatility likely will continue as markets adjust to the end of the easy-money era.

  • We expect the dollar to stay firm until there is evidence that the Fed is done tightening and/or global growth picks up.

Peak expectations

The worst may be over for the bond bear market. After more than two years of steadily rising bond yields (and falling bond prices, which move inversely to yields), our research suggests that 10-year Treasury bond yields may have peaked for this tightening cycle at the 3.25% level. The Federal Reserve likely will continue to raise short-term interest rates to about 3% in 2019, but we don’t see longer-term yields moving much above the recent highs. Tighter global monetary policy, a strong U.S. dollar and sluggish global growth exacerbated by trade conflicts are likely to weigh on economic growth and inflation, limiting the rise in bond yields.

However, the path forward isn’t likely to be smooth. As markets adjust to tightening financial conditions, volatility is likely to increase.

It’s stormy at the top

We expect the Federal Reserve to raise rates two to three more times, bringing the federal funds target rate to the 2.75% to 3% area in early 2019, short of  the Federal Open Market Committee’s 3.4% median estimate for 2020.¹ Because short- and long-term interest rates tend to converge at cycle peaks, the yield curve likely will flatten toward zero. We suggest investors gradually add to average portfolio duration when yields rise.

As the Fed normalizes rates and reduces its balance sheet, volatility may increase in riskier parts of the fixed income market—such as bank loans, high-yield and emerging-market bonds—due to issuers’ high leverage. We suggest investors move up in credit quality and/or limit exposure to these asset classes. Municipal bonds may post solid performance in 2019, as demand appears strong for tax-exempt income.

The 10-year Treasury yield and the federal funds rate both peaked around 9.6% in 1989, around 6.5% in 2000, and around 5.25% in 2006.

Takeaways

  • Consider adding to portfolio duration as bond yields rise, in order to capture more income, as the business cycle advances.
  • Consider moving up in corporate credit quality. Corporate bond market risks are rising, but the additional “yield premium” that both investment-grade and high-yield corporate bonds offer versus Treasuries remains relatively low.
  • Consider higher-rated municipal bonds, in the five- to eight-year part of the yield curve. Although muni credit quality is generally strong (albeit with pockets of risk), tight credit spreads don’t justify taking on additional credit risk.

 

¹Based on the FOMC Summary of Economic Projections, 09/26/2018

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Important Disclosures:

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data.

The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

Investing involves risk including loss of principal.

Data here are obtained from what are considered reliable sources; however, their accuracy, completeness, or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions.

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.

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.

High-yield bonds and lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

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

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