Interest rates are likely to remain in a compact range, facing minimal upward potential and significant downward potential.

January 2, 2019

To read the full article from Senior Fixed Income Strategist Doug Drabik, see the Investment Strategy Quarterly publication linked below.

The bond market played out the year in 2018 much as expected. The Treasury curve remained in a tight, albeit slightly higher, trading range as yields were bumped up across the curve, driven in part by four Federal Reserve (Fed) rate hikes. Short-term Treasury rates (less than one year) followed suit, rising approximately 1.00%, while intermediate- and long-term Treasury rates lagged. As a result, the Treasury yield curve continued to flatten over the year.

Several factors contributed to the rise in short-term rates: the economy grew at a positive clip, unemployment hovered at decade lows, inflation remained near the Fed’s target level, and Congress and the White House continued to push corporate-friendly agendas. However, geopolitical events and monetary policy abroad not only maintained, but, in many cases, widened interest-rate disparity.

Interest Rates: The Global Gap Widens

While it boosted 2018 growth substantially, fiscal stimulus is anticipated to be muted in 2019 due to the fact Republicans lost control of the House of Representatives in the most recent mid-term elections. Furthermore, receding corporate profits and the diminishing benefits of recent tax cuts may further slow the economic expansion in the U.S. Additionally, as the government’s budget deficit continues to widen, the incentive to keep interest rates low intensifies.

Global rate disparity has continued to widen (rather than narrow, as had been previously anticipated by many pundits). Active intervention by central banks around the globe, and the growth of their balance sheets appear to have peaked at the beginning of 2018, yet most central banks remain in an accommodative state. The aggregate assets of the Fed, the European Central Bank (ECB), the Bank of Japan (BOJ), and the People’s Bank of China (PBOC) reached holdings of $20.6 trillion U.S. dollars. This number has since declined to approximately $19.4 trillion U.S. dollars, an exceedingly large accumulation by any measure.

Fed Policy

In the short term, the Fed has committed to reducing its balance sheet of assets, thus reducing its impact as a buyer. Given that policymakers at the Fed have indicated interest rates are approaching a ‘neutral’ level, monetary policy in 2019 is expected to be softer than previously anticipated. While the Fed had been expected to hike interest rates up to four times in 2019, the probability of any hikes is now in question. As such, there is little to suggest that interest rates will make any dramatic moves upward over the next 12 months. The market has become rather proficient in accepting and adapting to monetary policy announcements. Exaggerated rate shifts are not expected as policymakers approach the neutral 3.00% federal funds target rate.

Onward, but Not Upward?

All of this suggests a continuation of the push-and-pull dynamic that has influenced interest rates for more than a year; however, the heightened uncertainty entering 2019 presents a more challenging interest rate forecast. If economic growth remains intact, the Treasury yield curve may continue its narrow trading range with the 10-year Treasury hovering between 2.70% and 3.40%, yet there are significant geopolitical and economic factors continuing to “pull” interest rates in the opposite direction. The conflicting undertows of economic data, fiscal policy, and monetary policy substantially impede the possibility of a massive rise in interest rates.

Political events are shifting rapidly as we write this outlook. A compromise on the European Union and Italian fiscal budget calmed the impasse but is subject to smooth enactment. The Brexit debate continues to stir insecurity. Additionally, China’s and the U.S.’ trade policy disagreement seems to shift from tolerable to gridlock every other day. As these events flare up, the uncertainty can push investors toward safe haven assets, such as U.S. Treasury securities, thus they limit the momentum market move toward higher interest rates. Should any of these politically charged events exhibit extreme results, the consequences could potentially empower a decisive flight to quality and plunge the 10-year Treasury rate range much lower toward 2.00% – 2.50%.

Portfolio Positioning

Appropriate allocation remains crucial to managing diversified portfolio risk. Allocations to fixed income may provide critical risk mitigation to other asset classes and act as a ballast for overall portfolio risk, particularly with equity exposure. However, many fixed income investors ultimately require more yield than can be provided by Treasury bonds or equity dividends. Corporate and municipal bonds are investments that typically provide higher income opportunities than Treasuries.

The Treasury yield curve is relatively flat compared to the municipal and corporate curves, which are over twice as steep as the Treasury curve. Given that both the corporate and municipal curves have steeper slopes, they reward investors who are willing to assume the risk of longer maturities with higher yields. The spreads between the yields on 1-year and 10-year bonds on the corporate and municipal yield curves are 1.01% and 1.34%, respectively, whereas the spread between the yields on 1-year and 10-year Treasuries stands at just 0.36%.

Going Forward

Interest rates are likely to remain in a compact range, facing minimal upward potential and significant downward potential. While some points of the Treasury yield curve have approached inversion, there remains some spread between intermediate- (5-10 year) and short-term (less than one year) yields. Barring significant geopolitical developments, the Treasury curve is expected to trade in a narrow range, with the yield on the 10-year Treasury between 2.75% and 3.40%.

Read the full January 2019 Investment Strategy Quarterly
Read the full January 2019 Investment Strategy Quarterly

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates, Inc. and are subject to change. Past performance may not be indicative of future results. There is no assurance that any investment strategy will be successful. Asset allocation and diversification do not guarantee a profit nor protect against a loss. Bond investments are subject to investment risks, including the possible loss of the principal amount invested. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, state or local taxes.

By | 2019-01-07T11:54:33+00:00 January 7th, 2019|Bond Market, Latest Articles|