What's ahead for the bond market?

One Fidelity expert says expect volatility, and focus on credit quality.

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Key takeaways

  • The Fed's rate hike was widely expected, as policymakers continue the process of normalizing interest rates.
  • Expect ongoing volatility as the world grapples with trade confrontations and uncertainty about the pace of growth while central banks tighten.
  • High-quality bonds look more appealing than lower-quality bonds, and it may make sense to hold exposure to floating-rate securities.

The Federal Reserve increased its target short-term rate to a range between 1.75% and 2.00%. The move marked the latest step in the Fed's campaign to bring monetary policy back to normal after pumping the economy full of liquidity following the financial crisis.

Viewpoints checked in with Tom DeMarco, CFA®, a market strategist in Fidelity Capital Markets' fixed income division, to ask him for his take on the Fed's moves, where it's likely headed next, and what it all means for bond investors. His perspective: The economy and the bond market look healthy, though there may be more volatility ahead. Consider high quality bonds.

What do you take away from the Fed's decision to raise interest rates?

DeMarco: I expected it, as did the market—the bond market had priced in a 100% chance of a rate hike prior to the announcement. Employment numbers continued to be quite strong, and although inflation numbers were not yet at the Fed’s target, they are moving in that direction and I think will soon be slightly above target.

I expect 4 rate hikes in total for 2018 as the Fed continues the process of normalizing interest rates.

Thus far, the Fed has not said much about global factors, such as the trade conflicts between the US and a number of other countries, or developments in emerging markets and the European Union. While these topics came up in the Fed's press conference, I think ultimately they will continue to get downplayed at this juncture.

Q. Why is the Fed's relative silence on those topics noteworthy?

DeMarco: A number of global developments have been affecting US markets. One is the back and forth on trade. Tariffs and escalating trade rhetoric are not good for markets, the economy, or inflation, especially if they lead to a full-blown trade war. Conversely, every time trade headlines look like they're becoming less threatening, the markets stage a relief rally.

Volatility in emerging markets and their currencies also has been affecting our markets, occasionally leading investors to sell off equities and seek a safe haven in US bonds. Fed actions, particularly the unwinding of quantitative easing, contribute to that volatility. That's why the Reserve Bank of India came out with an op-ed in the Financial Times asking the Fed to reconsider shrinking its balance sheet.

Issues in Europe also have influenced US markets. A couple of weeks ago it looked like there might be a snap election in Italy, which could have turned into a referendum on the euro. Investors sought safety in US Treasuries. When the snap election was averted, the flight to safety unwound.

All of these developments contribute to more volatile trading conditions—just what you'd expect when central banks are pulling back liquidity. Central banks are normalizing both policy rates and liquidity in their markets so that markets will, hopefully, learn to adjust to ongoing stresses on their own. If the Fed downplays all these international developments—rather than, say, slow the pace of its tightening and balance sheet normalization—we can expect more volatility.

What other factors have been driving the bond markets?

DeMarco: The market has been moving back and forth between fear of inflation and concern about the possibility that growth might slow.

A synchronized global expansion seemed to be in place at the beginning of the year. Recently we've seen some cracks in that narrative, with a string of poor economic numbers out of Europe. The ECB is trying to portray the softness as temporary and transitory, but that remains to be seen. And we have the problems in certain emerging markets, mainly Latin American markets such as Brazil and Argentina. I think risk markets such as equities and high-yield bonds generally will struggle if the narrative of synchronous global growth falls apart. The high-yield market needs growth and ample liquidity, along with interest rates that are low or at least not spiking. So a less positive outlook for growth would remove one leg of the stool.

I don't know whether growth actually will slow. But I think it's one of the things that markets are grappling with right now. Another is the tightening of global financial conditions, as central banks continue their normalization of monetary policy, leading to less easy conditions for the market.

You say you don't know whether growth will slow. What is your outlook on the economy?

DeMarco: I have something of a "Goldilocks" outlook: I don't see inflation running away, or interest rates jumping considerably higher, though I do expect rates to rise. Corporate earnings are incredibly strong for this year; 2019 may be less strong, but I think equity markets can still move up.

And I think we're closer to the end of the rate-hike cycle than we are to the beginning. Real interest rates, which are adjusted for the rate of inflation, remain low by long-term historical standards. So the question becomes, how far will the Fed go? I don't think they'll go much further. That, of course, assumes I am correct on the inflation outlook.

What upcoming developments will you be watching?

DeMarco: There's no lack of macro events to watch. In particular, I'll be keeping an eye on trade issues, including NAFTA negotiations and the trade confrontation with China, as well as the negotiations with North Korea. My hope is that these situations have outcomes that are at least neutral, if not favorable, which would allow equity markets to break higher. I think if that happens we could see interest rates break out of their recent holding pattern as well, with the 10-year Treasury yield moving back over 3% for the second half of the year.

What does all this mean to fixed income investors?

DeMarco: I think the possibility of higher interest rates warrants some exposure to floating-rate securities as well as an eye on duration, which is the measure of the sensitivity of the price of fixed income investment to a change in interest rates. And it's late in the economic cycle and not much in the markets is cheap, so I don't think it makes sense to go down in credit quality.

I continue to prefer some sectors that could benefit from economic growth, such as transportation and the big banks and brokers. I generally like securities issued by oil exploration and production, in part because I think oil prices could remain in the mid- to upper-$60 per barrel range for a while. I'd be underweight in the media sector in general, but I like certain names. Likewise, retail is facing some severe challenges, but certain companies in the sector are managing relatively well.

I'd be cautious about bonds issued by medical devices and pharmaceutical companies, due to the potential for headline risk. And I'm cautious on aerospace and defense, because I don't think the bonds are cheap and the companies may reward shareholders at the expense of bondholders.

What is your outlook for municipal bonds?

DeMarco: Munis can be a good place to invest late in the economic cycle. That said, I think current valuations are not cheap. One reason is that the technicals in the muni market are quite strong right now. By my estimation, through the summer we’ll have negative net supply (meaning redemptions and coupon payments in excess of issuance) in the muni sector of negative $60 billion. There is a seasonal factor, but this year it is a bit bigger than average. And fundamentals look fine, with solid economic growth and healthy tax collections. So I think munis will continue to hold their own, especially through the technically strong summer months.

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