Head - Fixed Income Strategy
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With many investors too pessimistic about the economic outlook, we believe US Treasury yields could reverse some of their recent decline later in 2019.
What a difference four months can make. In early November 2018, the yield on US 10-year Treasury bonds had surged to a seven-year high of 3.24%. Growing optimism about the US economic outlook, firming inflation, and Fed projections of several interest rate hikes in 2019 all helped fuel the move. The case for continued upside in US Treasury yields – and therefore downside in prices – seemed plausible. Fast forward to March 2019, however, and things look rather different. The US 10-year yield has dropped back to 2.60%. So, why the retreat and what might we expect next?
Fears over the health of the economic expansion both in the US and globally have altered the likely path of US interest rates in 2019. The market turbulence triggered by those fears at the end of last year has forced the Federal Reserve to pull back from its more aggressive rate-hiking plans. We now believe the likeliest scenario is that the Fed either raises rates once more in 2019 or not at all. However, policy tightening may only occur once warning signs on the US expansion dissipate and growth shows signs of renewed strength. Meanwhile, we expect the Fed to start fully reinvesting the proceeds of its maturing Treasury holdings and agency mortgage-backed securities once again. This would mark a break with its tightening policy of not fully reinvesting the proceeds of maturing securities that’s been in place since October 2017.
Despite the Fed’s change of course, many investors remain pessimistic about the US economic outlook. This is reflected in market pricing that implies interest rate cuts in 2019. We do not share that view, however. As a result of the Fed’s dovish shift, we believe the likelihood of a recession in 2019 or 2020 has fallen. It is possible that growth could start to strengthen again in the second half of the year and that the US signs new trade deals. While the hurdle for additional rate hikes is high, such developments could prompt US 10-year yields to push back toward 3%.
So, what should investors do in this environment? We are overweight short and intermediate term maturity US Treasury and investment corporates. Our expectation is that the US 10-year yield will likely remain range-bound between 2.5 and 3% in 2019. We remain neutral duration, but would consider increasing exposure to longer-dated bonds in the event of any meaningful rise in long-term yields. That said, we still advocate diversifying duration exposures across the curve when building portfolios. US yields remain the most attractive fixed income opportunity in the developed world. And, longer-term Treasury bonds can still offer insurance during surprise risk-off events.
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Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.