Bond Yields Will Rise in 2018

Good news for income investors - fixed income is going to pay a better rate of interest next year, says Morningstar's Peter Gee

Peter Gee 27 December, 2017 | 11:16AM

The process of normalisation of interest rates in the major developed economies is, very slowly and gradually, getting under way, and interest rates look likely to rise in 2018, creating issues for bond investors. At the Fed’s latest meeting, the policy participants made forecasts of where they think the Fed fund rates will go over the next few years. This time round, the forecasts were, on average, for three further 0.25% increases by the Fed in 2018. That’s rather more than financial markets currently think will actually happen.

Futures prices, as recast in the CME Group’s “FedWatch” tool, say there is only a 7% chance of all three increases, with only one looking rather more likely. But either way the Fed is clearly moving away from its previous very stimulative stance, via both higher short-term rates and a wind-down of its bond-buying, which had been keeping bond yields low.

Some other major central banks have also moved away from their previously ultra-easy policy, notably the Bank of Canada and the Bank of England. However, the European Central Bank thus far has only reached the point of buying fewer bonds each month than previously: It is still adding to its stock, whereas the Fed has progressed to running down its stockpile.

The Fed Leads the Way

At its latest policy meeting on December 14 the ECB made it clear any outright retreat from its current stimulus is still a long way away. And the Bank of Japan will be keeping to its current very low interest-rate policy for the indefinite future. Overall, however, the outlook is that the regime of ultralow interest rates is gradually likely to be chipped away, which is to be expected when all the evidence suggests that the global economy is strengthening and less in need of such unusual levels of monetary policy support.

Even in Europe, the recent strength of the eurozone economy suggests that we may see the ECB moving a bit faster to normalise policy than it currently expects. The upshot is that bond yields, more in the U.S. than elsewhere, are likely to rise.

The latest Wall Street Journal poll of U.S. economic forecasters expects a 2.9% U.S. 10-year yield by the end of 2018, and 3.25% by the end of 2019. The expected rises are not dramatic, but they are likely to be a consistent headwind for fixed-asset performance. There are alternative scenarios.

The Puzzle of Inflation

One is the major puzzle, which economists and policy makers have not cracked, of inflation staying very low even when economies like the U.S. are in strong shape, the latest U.S. unemployment rate is only 4.1%. If inflation continues to surprise on the downside, upwards pressures on bond yields could be less.

Another potential positive is the value of bonds as insurance against any unexpected setback to the U.S. or global economies. While that does not look likely at the moment, the current U.S. expansion is already quite mature: The American economy came out of the global financial crisis recession in late 2009, so the current expansion is eight years old, quite lengthy by historical standards. Late in economic cycles, accidents can happen, and might reignite demand for safe-haven government bonds.

On the other hand, an unexpected economic setback would be very unwelcome news for the parts of the bond market that have lately been most in favour, the junkier end, and the emerging markets. There have been some genuine reasons for these sub-classes doing well, turnarounds like Ireland and Portugal, and a largely synchronised global cycle that has lifted many emerging economies with it, but any unexpected slowdown would be likely to see a rapid re-evaluation of what investors need as compensation for the true risks involved.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Peter Gee  is a Fund Analyst for Morningstar Australia