2018 outlook: navigating rate hikes

High valuations on corporate bonds may make Treasuries relatively attractive.

  • Ford O'Neil, Portfolio manager, Fidelity Total Bond Fund
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Key takeaways

  • The market may be underestimating the pace of rate hikes. 
  • Rising rates may have more of an impact on shorter-maturity bonds. 
  • High-yield and investment-grade corporate bonds look relatively expensive. 
  • Consider Treasuries to help hedge credit risk.

With the economy on solid footing and the US gross domestic product rising a better-than-expected 3% or more in the past 2 quarters, the US Federal Reserve continues to express confidence that the strength of the job market and overall economy will justify further gradual increases in interest rates in 2018. At its mid-December meeting, the Fed raised its benchmark rate by a quarter of a percentage point to 1.50% and signaled that it was prepared to make as many as 3 additional rate hikes in 2018. But market participants seemed more optimistic as the Fed funds futures pricing suggested only 1 or 2 rate hikes this year.

Viewpoints spoke with Ford O'Neil, manager of Fidelity® Total Bond Fund for his perspective.

O'Neil: My view is that there will likely be 3 rate hikes in 2018.

I believe an increasingly synchronized global economic recovery is occurring, which is causing some inflationary pressures to build. I'm still a big believer in the Phillips curve model, which says that when unemployment falls, inflation should rise, because more workers with jobs will increase consumer demand in a stronger economy, and that, in turn, should lift prices. With US unemployment approaching generational lows of 4%, I think inflation will be higher in 2018, and this will include upward pressure on wages.

Against this economic backdrop, I expect bond yields across the yield curve to move higher as the Fed hikes rates, although I believe yields on shorter-maturity bonds will likely rise proportionally more than yields on longer-term securities. Nonetheless, rising yields will likely put pressure on all bond prices.

The unwinding of quantitative easing policies—whereby the Fed and other central banks around the world bought government bonds in an effort to keep interest rates low—could also weigh on the prices of government securities. The Fed has indicated it will accelerate its efforts to reduce its balance sheet through the gradual sales of its US Treasury and government-agency mortgage-backed security holdings.

Risk assets seem priced for perfection

Credit spreads (the difference in yields between Treasuries and riskier bonds) could widen in 2018. Normally, credit spreads widen due to the onset of a recession. However, if you think about the past 8 years, although we haven't had a recession, we've had a number of periods when credit spreads widened—the European banking crisis of 2011, the "taper tantrum" of 2013, and the downturn in commodity prices in 2015.

In my view, riskier assets are "priced for perfection," and even absent a recession, credit spreads could be wider a year from now. As a result, I don't see as much value in fixed income spread sectors like high-yield and even investment-grade bonds, especially compared with a year ago. The incremental yield offered by bonds with credit risk relative to US Treasuries has narrowed.

My concern is that spreads eventually will widen, causing investors to revalue riskier assets. Even if prices for riskier assets continue to climb, I think investors, at some point, will balk at their high valuations and seek better value elsewhere.

Additionally, volatility in the bond market is, by some measures, as low as it's been in a very long time. My view is that no one can know for sure when volatility will tick higher, but, ultimately, it will revert to its historical average, or even overshoot that.

For these reasons, I'm currently approaching riskier fixed income assets with a degree of caution, limiting exposure to high-yield and investment-grade corporate bonds. I'm also guarded about the prospects for agency mortgage-backed securities; I think this segment may face a significant headwind as the Fed continues to shrink its balance sheet by scaling back its purchases of such securities and letting its holdings mature over time.

In the core bond funds I manage, I'm using US Treasuries to help reduce the credit risk of my portfolios, which also affords me the luxury of having some "dry powder" to redeploy into spread sectors, once I think valuations have improved.

Always opportunities

All this being said, I think the past 8 years have proven that even when there were expectations that interest rates would rise, a number of headwinds curtailed just how high rates could go. The aging population increasingly wanted more fixed income in their portfolios. Additionally, yields on European and Asian bonds were lower than comparable US securities, so US bonds benefited from overseas demand. I believe these 2 trends will continue into 2018 and be, potentially, important stabilizing factors for fixed income assets.

Regardless of the market backdrop, there are always opportunities.

Next steps to consider

Visit Fidelity's fixed income, bond & CD page.

Review your bond holdings and see your rate risk.

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