Rate Volatility Likely as Year Progresses
Short rates set to rise, with long rates range-bound
Rates will dominate fixed income returns
Expect positive but below trend returns
Our forecast entering 2018 suggested that fixed income returns would be affected primarily by higher rates, firming inflation, and the Federal Reserve. This view has proven correct, with the Bloomberg Barclays Aggregate Bond Index declining 1.46% in the opening months of 2018. Market rates rose in the first part of the quarter due to the tax cuts, rising optimism by businesses and consumers, and a commensurate increase in inflation expectations. As the quarter wound down, this optimism faded as consumption remained weak, policy uncertainty increased, and stock market volatility returned. As of this writing, the 10-year Treasury is up 35 basis points but remains 20 basis points below its 2.95% peak on Feb. 21.
The Fed, led by new chairman Jerome Powell, has played a large and visible role in market sentiment as the Federal Open Market Committee progresses further down its well-broadcast path of gradual rate hikes. In response to stronger fundamental factors and more hawkish voters joining the FOMC, City National Rochdale increased its expectations from three to four hikes this year (one more than Fed projections).
This expectation is largely priced into shorter maturity bonds, but inflation remains the key driver for longer-term yields. Deficit spending, coupled with an accelerating economic growth trajectory, led the market to price in higher inflation in the future, hurting long-term bonds for most of the quarter. This has largely reversed, however, as actual inflation remains subdued and the trade war heats up.
Looking forward, we expect continued volatility in rates as uncertainty about recent fiscal stimulus, future policy actions, Fed rate hikes, and the budget deficit weigh on sentiment. We are targeting neutral to short duration and utilizing a barbell structure to capture the anticipated further flattening of the yield curve. In anticipation of a potential turn in the credit cycle in 2019-2020, we are taking advantage of tight credit spreads and strong markets to upgrade the quality of our portfolios. Overall, we continue to expect returns for investment grade fixed income in the lower single digits this year with greater potential upside in the opportunistic income sectors.