Bond Market Crosscurrents to Make for Tricky 2018
The end of the year is upon us, which means it’s time for some big-picture thinking on the bond market. I’m never wedded to my year-ahead views, but they serve as a road map and keep me aware of where things change and where I’m wrong. With that, here are the highlights.
- The Federal Reserve just raised its main interest rate to 1.5 percent, and the market is pricing in a rate just above 1.87 percent by the end of 2018, with a 30 percent chance of 2 percent to 2.25 percent. I give more odds to the latter, especially if some of the Fed’s alternative views on inflation influence policy. A recent San Francisco Fed report titled “What’s Down With Inflation?” says pro-cyclical inflation is at pre-recession levels while a-cyclical ones are temporary, such as lower Medicare and health care costs.
- Overall growth to remain modest, along the 2.1 percent lines that have been the average since 2012. The Republican tax plan might help, but I’m just not sure if that’s 2018 or 2019. The expansion has been a long one, and there are some late-cycle elements that make me more cautious. Base effects could lift inflation early in the year, maybe aided by oil, commodities and the dollar. I don’t think it will last, but it gives the Fed cover.
- I hate being in the consensus, but with Fed transparency and the Treasury's borrowing plans, there’s reason to expect upward pressure on the front end of the yield curve. And I do think 10-year Treasury yields can probe the post-election high near 2.64 percent and perhaps take a stab at the 2.75 percent to 2.90 percent range. If that happens, then I would deem it a buying opportunity, pulling yields back down into the 2.20 percent to 2.50 percent range in the second half of the year. The bull market in bonds may be over, but I don’t believe we’ve entered a major bear market.
- The budget deficit was going to rise sharply before the consequences of the tax plan. The Treasury wants the increase in debt-financing to be concentrated in shorter maturities, which along with Fed rate hikes means more pressure on the front end relative to the back end of the yield curve, flatting it even more.
- While the Treasury has backed away from adding longer-term debt, I don’t believe that can last. First, all issuance will have to rise as the deficit expands. Second, the logic of a flatter curve, with rates still low, makes a compelling case for more 30-year bonds and the introduction of maybe 40- and 50-year bonds. This isn’t a 2018 issue, but the debate will go on and I think becomes serious later in the year.
- There’s rising risk that the Republicans lose a lot of seats in the midterm elections, raising uncertainty. The GOP tax plan is not reform but deficit-financed tax cuts; the GDP impact remains to be seen. The Joint Committee on Taxation says it will increase GDP by just 0.8 percent over 10 years in total. Further, while it’s good for corporations and the wealthy, it will be neutral for many and downright negative for those in high-tax states. This plan is not exactly popular with the electorate, with only a 25 percent to 29 percent approval rating.
- With central banks taking away the proverbial punch bowls, equity markets at record highs, credit spreads taut, and, yes, things like bitcoin reeking of a speculative bubble, I look for, ahem, subdued returns. To the extent easy money, negative rates, and central bank balance sheets have aided the bullish behavior in risk assets, then the follow through is that the slowing of such activities from central banks would have a dragging effect. One could make the same case for higher rates, of course, but that influence seems more related to curve flattening in the form of rising short-term yields, at least in the U.S., versus any dire consequences being flagged further out the curve.
- U.S. corporations have incurred a massive amount of debt relative to GDP and used it for buybacks and other activities unrelated to expansion or productivity-enhancing investment. Various surveys and anecdotes suggest that corporations will use lower taxes to 1) pay down debt, 2) buy back stock, and 3) look to mergers and acquisitions.
- The growth in exchange-traded funds creates a concern for me in the event of a bear market -- or even a bull market, I suppose. ETFs are liquid but their assets are not, so if there’s a panic then the selling pressure can exacerbate price deterioration. I’m thinking about the less liquid areas like high yield and emerging markets. The flip side to that is if active managers have added more risky things to their portfolios to enhance performance, they may be forced to sell in a bear market for such assets. My sense is neither dealers nor hedge funds have the liquidity to handle such an event.
- Demographics are such a big topic that a mere bullet point doesn’t do the theme justice. The population is growing older, which has implications for more conservative spending and investment habits. Wages gains for aging populations are slow to negative as older workers are 1) less productive, 2) less upwardly mobile, 3) less geographically mobile, and 4) less demanding on wages and more interested in flexible hours and health benefits. The benefits they expect have to be paid for, which means higher taxes, benefit reductions or a combination of both. The uncertainty surely will weigh on spending to encourage savings.
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