By Kathy A Jones
After more than two years of steadily rising interest rates, we believe 2019 could mark the peak in U.S. Treasury yields for the current business cycle. However, while the prospect of more stable or lower interest rates may be positive for bond investors, the road ahead is likely to be bumpy. We expect the Federal Reserve to continue raising short-term interest rates and reducing its balance sheet, leaving riskier, more leveraged segments of the market vulnerable to price declines.
It's stormy at the top
In our view, 2018 was a transition year from the era of easy money - characterized by low interest rates and bond-buying programs by major central banks - to gradually tighter monetary policy. After nearly a decade of zero to negative short-term interest rates and central banks expanding their balance sheets, the trend is now toward tighter money. In 2019, the total net assets on the balance sheets of major central banks are projected to shrink.
Central bank balance sheets are declining
Source: Schwab Center for Financial Research with data from the Federal Reserve, European Central Bank (ECB), and the Bank of Japan (BoJ). The ECB net monthly purchases assume a constant 1.15 USD/EUR exchange rate while the BoJ net monthly purchases assume a constant 113 JPY/USD exchange rate.
Note: BoJ net monthly purchases assume annual purchases of 45 trillion yen each year. Despite the BoJ's official commitment to purchase 80 trillion yen annually, purchases for the six months ending September 2018 averaged roughly 45 trillion yen. Please note that all future dates are projections.
The consequences of tighter money are likely to be higher volatility and re-pricing of riskier assets, such as high-yield and emerging market bonds. When central banks were trying to push money into the economy to stimulate growth, they kept the rate on "risk-free" investments (such as Treasury bills) near zero. As a result, risk premia - that is, the additional compensation investors demand for accepting extra risk - were lowered.
Consequently, most forms of risk-taking were rewarded with strong returns. However, now that the risk-free rate has moved up and central banks are gradually reducing the amount of money flowing to the economy, markets are reassessing the valuations of riskier assets and volatility is rising.
The good news is that the bond market has already gone a long way in this process, especially in the U.S. Short-term rates have been moving higher since late 2015 and 10-year Treasury yields have more than doubled over the course of the past two and a half years. It hasn't been a smooth ride by any means - for example, the Bloomberg Barclays U.S. Aggregate Bond Index is on pace to post its first negative annual total return since 2013. However, real yields-that is, after inflation-have moved up, which represents a return to more normal monetary policy.
Outlook for 2019: Passing the summit
Looking into 2019, we see the potential for intermediate- to long-term bond yields to hit a cyclical peak on expectations that economic growth and inflation will moderate due to the waning effects of last year's fiscal stimulus, tighter Fed policy, sluggish global growth and the lagged effect of a strong dollar. In our view, U.S. bond yields already appear high relative to current global economic conditions. As the chart below illustrates, global purchasing managers' indexes (PMIs) have been dropping, signaling a potential economic slowdown, and have diverged from the trend in 10-year Treasury yields.
Global PMIs have weakened and diverged from 10-year Treasury yields
Source: FactSet, Bloomberg. JP Morgan Global PMI Composite Sector, Output Index, SA - World, 10-Year Treasury Constant Maturity Rate (USGG10YR). Monthly data as of 9/28/18. Past performance is no guarantee of future results.
Moreover, 10-year Treasury yields are already at levels that assume the Federal Reserve will make four to five more 25-basis point hikes to the federal funds rate, currently at 2.25%, over the next two years (a basis point is one-hundredth of one percent, making 25 basis points equal to 0.25%). That would bring the funds rate to as much as 3.5% by the end of 2020.
Because long- and short-term rates tend to converge as the Fed tightens, at 3.25%, the 10-year yield is near the lower end of the range for the Fed's projected rate hikes. However, we would not be surprised to see the Fed pause or end its rate hikes short of that level, especially if the yield curve - the difference between short and long-term interest rates - flattens to the point that it approaches zero.
10-year Treasury yields tend to peak near the peak federal funds rate of a given cycle
Source: Federal Reserve Bank of St. Louis. Effective Federal Funds Rate, (FEDFUNDS) and 10-Year Treasury Constant Maturity Rate, Percent, Monthly, Not Seasonally Adjusted (DGS10). Data as of 11/1/2018.
In addition to our expectation that growth will slow domestically and remain soft abroad, inflation and inflation expectations remain subdued. Although the unemployment rate is quite low and wages are rising, it hasn't translated into significantly higher inflation because the link between a low jobless rate and inflation is much looser now than in the past.
It appears that a combination of long term and short-term factors is keeping inflation in check in this cycle. In the long run, aging populations, globalization and technological change are keeping prices for many goods and services from rising strongly. In the shorter run, the strong dollar which is dampening import prices and pushing commodity prices lower, is limiting inflation.
For the Fed and the bond market, the key signal is that inflation expectations remain subdued. Both market-based and survey-based measures of inflation expectations are low.
Survey-based inflation expectations have steadily fallen…
Source: Surveys of Consumers, University of Michigan, University of Michigan: Inflation Expectation©. Monthly data as of October 2018.
… while market-based inflation expectations remain anchored near the Fed's 2% target.
Source: Federal Reserve Bank of St. Louis. 10-Year Break-even Inflation Rate, Percent, Monthly, Not Seasonally Adjusted. Monthly data as of October 2018.
Note: Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.
Expectations are important because they can affect behavior. If consumers expect higher prices ahead, they have an incentive to buy goods and services today or even borrow to make those purchases. However, the opposite is true. If prices are expected to remain steady, there is no rush to increase consumption or prices.
Investment strategy on the other side of the peak
If we're right that intermediate to long-term yields are at or near a peak, then investors should consider modestly increasing in the average duration in their fixed income portfolios. We are shifting our suggested average duration for Treasuries and other taxable bonds to the two- to seven-year range, from two to five years. For municipal bonds, we see better valuation in the five- to eight-year range.
Investors should also consider moving up in credit quality within the tiers of the corporate and municipal bond markets. As growth slows and financial conditions tighten, credit spreads - the yield premium investors receive for investing in riskier bonds-tend to widen to compensate for those rising economic risks, lowering prices. We also continue to maintain an underweight to emerging market bonds.
The major risks to our view:
- Stronger global growth: If economic growth abroad were to rebound above the long-term trend rate, it would likely cause bond yields outside the U.S. to rise, pulling U.S. yields higher. We are monitoring the leading indicators of economic growth in other major countries to keep an eye on these trends.
- Weaker dollar: The dollar's rise over the past few years has reflected the relative strength of U.S. economic growth and the wide yield differential with other major countries. A stronger dollar tends to make U.S. assets more attractive and dampen inflation. Therefore, if the dollar were to drop for reasons other than the prospect for slower growth, it could make U.S. assets less attractive to foreign investors and cause bond yields to rise.
- Higher inflation expectations due to soft Fed policy: If the Fed is seen as getting "behind the curve" on inflation it could cause bond yields to rise.
- Increased supply: In the long run, there is a risk to the bond market from rising deficits and debt levels. Higher debt levels require increased issuance of bonds by the Treasury, increasing the supply that needs to be absorbed by the public. Because the U.S. relies on foreign investors to help finance the deficits, attracting foreign capital could require higher yields. We don't see this as a risk in the short run, but it could become a market issue in the long run.