Higher Volatility, Lower Returns Likely in the 2018 Bond Market

Surprisingly, the Bloomberg Barclays Capital US Aggregate Index generated a return of 3.54% for the year 2017, even though the Federal Reserve raised the fed funds rate three times to end the year at a targeted range of 1.25%‒1.50%. Two-year Treasury yields rose 70 bps in response to the rate hikes. Although the Fed can influence short-term interest rates, the market’s expectation for inflation has a greater influence on longer-term interest rates such as 10-year and 30-year US Treasury securities. 

The Fed’s preferred inflation measure, the Core Personal Consumption Expenditure Price Index, started the year at 1.90%, just short of the Fed’s target level of 2.0%. By December, the YoY Core PCE rate fell to 1.50%. The decline was one of the reasons the 30-year US Treasury yield dropped from 3.07% at the year’s inception to 2.74% by year end. The rise in two-year Treasury yields, coupled with the decline in longer-term rates, has flattened the 2s‒10s yield curve by 73 basis points to a year-end spread of 52 basis points, the lowest level since October 2010.

Fixed income returns were also positively impacted by the strong performance of spread product versus similar-duration Treasury securities, including corporates and asset-backed, commercial mortgage-backed, and mortgage-backed securities. High yield securities also performed well, generating a return of just over 6.0% for the year (as measured by the Bank of America Merrill Lynch High Yield Master Index).  Corporates benefited from robust corporate earnings growth and strong demand from domestic and international buyers in search of higher-yielding securities.

Given the market events of 2017, what might fixed income investors expect in 2018? Unfortunately, lower returns.  In our view, investors should not expect to earn a return higher than the yield of the Bloomberg Barclays Aggregate Index, which was 2.71% at year end.  Our projection is based on our belief that the Fed will achieve its target of raising the fed funds rate three times this year, with the risk of an additional hike greater than the risk of fewer hikes.  We also expect inflation to gradually rise to 2.0% as a tight labor market eventually leads to higher wages and an expanding global economy leads to higher commodity prices. 

We expect a flatter yield curve in 2018 but not an inverted curve, which typically precedes a recession. Despite spread product experiencing two years of strong excess returns, we believe the trend will continue. Solid earnings growth and demand from domestic and international investors should lead to better returns in credit compared to US Treasuries. Overall, we believe investors are likely to experience higher volatility and lower aggregate bond returns this year versus what they enjoyed in 2017. 

 

Mike Vandenbossche, CFA

Executive Vice President, Deputy Chief Investment Officer, Fixed Income

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.