In an environment where the global economy can turn on a tweet, it’s helpful to have expert guidance into a volatile bond market. We spoke with Craig Elder, Senior Fixed Income Analyst and author of Baird’s Fixed Income Weekly, for his thoughts on what investors and issuers can expect in the remaining months of 2017.
How would you characterize the bond market’s performance in the first six months of the year?
When looking at the fixed income market, it’s good to start with what’s traditionally moved the interest rates: the Fed and the makeup of the FOMC members, unemployment reports and inflation levels. Lately, though, I think there’s another major factor in determining interest rates – what I call the “technical flows” of bonds and notes controlled by the central banks. In the United States, there's about $15 trillion dollars in tradable debt, and the Fed owns $2.3–2.4 trillion of that. When the Fed started the conversation of when and how it would cut back its balance sheet of tradable debt this past June, they may have helped keep interest rates lower over the past month, with the 10-year municipal market data (MMD) and U.S. Treasury being only 10–15 bps above their lows for the year.
Against that backdrop, we believe that despite the current low interest rate environment and the Fed raising rates twice already this year, investors’ bond market returns were better than expected. The bond market return was 2.3% in the first half of the year, according to the Barclays Bloomberg Aggregate Bond Index. Bond investors were paid to take credit risk, as high-yield had almost a 5% return, investment-grade corporates had a 3.8% return and municipal bonds had a 3.6% return. As far as the interest rates themselves go, although municipal and Treasury rates are higher than they were last year at this time, they have come down somewhat from highs reached in early March. As expected, with an increase in yields came a decrease in municipal supply, with issuance down by 12–13% compared to 2016’s record high.
What do you expect for the remainder of 2017?
We think the yield on the benchmark 10-year Treasury note should trade in the 2.60% to 2.75% range by the end of the year, and then go above 3% next year. We’re especially keeping an eye on what the Federal Reserve will be doing. For years the Fed has “put the punch bowl out for the party” through accommodative interest rate and economic policies. What we believe we’re seeing now is the Fed beginning to pull the punch bowl away. In June they announced the mechanics of reducing their $4.5 trillion balance sheet, most likely beginning later this year. How the bond market will react when this happens is hard to say – in 5,000 years of interest rate history, we’ve never had a central bank attempt to downsize its balance sheet by $2 trillion. Our best guess is it will put some upward pressure on Treasury yields (10–20 basis points on the 10-year Treasury note yield), as the Fed will no longer be purchasing them at Treasury auctions. The impact will possibly be felt more, however, in mortgage-backed securities, which could experience some spread widening.
We also have to keep in mind the Fed is going to go through some fairly major “personnel changes” over the next 12 months. President Trump recently named Randal Quarles, who is thought to have a somewhat hawkish reputation, to one of the three vacant Board of Governors seats. Other rumored replacements appear to have more of a hawkish bias as well. Meanwhile, Fed Chair Janet Yellen's term ends in February and Fed Vice Chair Stanley Fischer's term ends in June of next year. These changes could result in an FOMC that is more hawkish than the current makeup of the committee.
If the Fed announced they were selling off their inventory of Treasury and mortgage-backed securities, would you anticipate a repeat of 2013’s “taper tantrum?”
We don't think so. They've already laid out for the markets how the sell-off would work. They'd start at $10 billion per month for one quarter – $6 billion in Treasurys and $4 billion in mortgage-backeds, not that significant when you're holding $4.5 trillion in inventory. Then they’ll start increasing that by $10 billion every quarter until they reach $30 billion in Treasurys per month and $20 billion in mortgage-backeds. It’s expected that would be achieved by the end of 2018. I don't know how you could be more transparent than that – especially compared to the taper tantrum, where they didn't publicize it enough ahead of time. They seem to have learned that they shouldn’t surprise the markets.
Are you anticipating further rate increases going forward?
The Fed Funds Futures are forecasting one rate hike this year, probably in December, and two in 2018. The Fed has always said that when deciding to raise or lower rates, they're data-dependent, which makes you think inflation numbers or unemployment rates. But the Fed is also looking at the equity (stock) markets – if they continue to rally, we wouldn’t be surprised to see the Fed raise interest rates another 25 basis points in September in an attempt to prevent an equity market bubble from developing.
Tax reform would certainly impact the fixed income market. What changes in tax policy do you see coming out of Washington?
We might get a small cut in corporate tax rates, maybe from 35% to 28%, though that would be more likely to take effect next year than in 2017. If they could enact tax reform, we could also see lower individual taxes, but we doubt they would be significant, given the need for any changes in tax policy to be revenue-neutral for the federal government.
Other revenue-neutral tax reform ideas include the elimination of the mortgage rate deduction, the elimination of the deductibility of interest payments by corporations and the taxation of municipal bond interest. Of these, we think the most likely to be enacted in a tax bill would be the elimination of deductibility of interest payments by corporations. We think it unlikely that home mortgage interest deductions would be eliminated and give the taxation of municipal debt payments virtually no chance.
Any final advice for fixed income investors?
No matter what’s happening in the equity market, it’s important you allocate to fixed income. As we saw in the equity markets in 2008–2009, stock market investments can be very volatile. As to your fixed income portfolio allocations, we would advise to continue to ladder your portfolios: four to twelve years in munis and three to eight years in taxable bonds. Just keep in mind that going from 2.40% to 3% at the end of the year is not going be the death of your portfolio. Just follow your plan and asset allocate appropriately.