Return to Insights

Fixed income summary and outlook


Bonds outperform stocks in 2018 equities

Bonds were the top performing asset class in 2018 as the fixed income market was relatively stable while the equity markets gyrated. While interest rates rose, the increase was not as much as investors expected. Most pundits predicted that the 10-year Treasury note would yield well north of 3% at year end. However, the yield at year end was 2.68%, not much higher than the 2.40% at the end of 2017.

Bonds surprise investors as 10-year Treasury yields close the year under 3%

In early 2018, analysts believed that U.S. tax cuts and increased government spending would stimulate the economy and cause inflation to rise. Bond yields climbed as bets on accelerating growth and inflation drove prices sharply down (Bond yields rise when prices fall). Ten-year bond yields rose over 3%, reaching a seven year high of 3.23% in November.

Bond yields dropped to their year-end level of 2.68% when political events, uneasiness over tariffs and lower oil prices raised concerns that the economy might weaken in 2019. Weaker economic growth and low oil prices usually lead to lower inflation and lower bond yields.

Trade tensions and tariffs reduce growth and profitability by raising uncertainty and costs for many companies. Also, rising rates are spurring concerns that interest-rate-sensitive sectors of the economy, such as the housing market, will slow down as mortgage rates rise. The housing market has been losing momentum; pending house sales dropped 11 months in a row in 2018. Lastly, oil’s slide below $50 a barrel reduced inflation expectations, raising demand for bonds.

The Federal Reserve hikes rates. More in store for 2019?

The outlook for rate hikes in 2019 is cloudy and could change at any time. Recently, Chairman Jerome Powell and other members of the Federal Open Market Committee indicated that they are likely to proceed with hikes in March and September. Job creation is strong and unemployment is low. Nonetheless, the global slide in risky assets, along with data showing a steep decline in U.S. manufacturing activity and a recent warning by Apple over iPhone sales, may give the Fed pause.

Many investors are concerned that the Federal Reserve will raise interest rates too aggressively in 2019 and cause a recession.

There have been nine interest rate hikes since 2015, including four hikes of 25 basis points each in 2018, ending at the current Fed Funds level of 2.375%. The Fed’s most recent “dot plot” indicates there will be two more rate hikes in 2019 — compared to previous expectations that the Fed would raise rates three or more times in 2019.

The recent slowdown in the world economy and stock market decline are causing many investors to believe, however, that there won’t be any Fed rate hikes in 2019. According to the Fed Funds futures, the odds of a rate cut are now higher than the odds of a rate hike, and, as of early January 2019, the Fed Funds futures predict that the Fed will not hike rates at all this year.

Will the yield curve invert in 2019?

The yield curve was flat throughout 2018. Short-term rates rose in response to rate hikes by the Fed, while longer term rates also rose but then fell in the second half of the year. The combination of higher short-term rates and lower long-term rates created the flat yield curve.

Right now, the yield curve is partially inverted as the 5-year Treasury yields at 2.49%, less than the top of the Fed’s 2.25%- 2.50% target rate for the Fed Fund’s rate. The 1-year note at 2.57% also yields more than a 7-year Treasury note at 2.56%. The current inversion is being created because investors are concerned that the Fed is tightening too aggressively — this causes short-term rates to rise. Lower rates for longer term bonds indicate that the economy will slow down from overly aggressive tightening.

Although it’s commonly believed the inverted yield curves precede recessions, the reality is that inverted yield curves have sent a number of false signals in the past. The curve inverted

in 1998 around the time of the Long-Term Capital Management crisis, but the Fed cut rates quickly and avoided a recession.

The most recent inversion was 2006 when the yield curve fully inverted, with 10-year yields below all shorter maturities. Stocks continued to rally until the bust and the Great Recession of 2007-2009.

The yield curve doesn’t officially predict a recession until the 10-year bond yield falls and stays below the 3-year bond yield for a sustained period of time. The 10-year bond yield is currently about 20 basis points higher than the 3-year yield, so is not yet predicting a recession.

While the shape of today’s yield curve bears watching, investors need to remember that the market is full of uncertainties.

The curve is not yet inverted, and inverted curves do not always predict recessions. Historically, there is an 18-24 month lead time between yield curve and a recession, and the curve is mostly flat, not inverted.

Our fixed income strategy for 2019

We are making some changes to our fixed income strategy based on the 2019 outlook for a continued flat yield curve, and stock and bond market volatility. We expect economic growth and interest rates to remain low overseas, so we are selling our international bond fund in anticipation of better returns in the United States. Proceeds from the international bond fund will be invested in a short-term bond fund. Short-term bond funds have an attractive risk/reward profile because of the flat yield curve — its yield is close to the yield of intermediate term bond funds with longer durations (and higher interest rate risk).

Our positions in the high yield and bank loan funds will not change. Despite recent volatility in these markets, default rates remain at very low levels (below 3%) and valuations are attractive. We are also not making any changes to the fixed income in our tax-exempt portfolios at this time.