Bond yields have room to move higher in 2020 as recession fears ease. Barring a setback on trade, 10-year Treasury yields could move back up to the 2.25% to 2.50% area.
The Federal Reserve is likely on hold for the foreseeable future. The three cuts in 2019 “un-inverted” the yield curve and eased financial conditions.
Risks are rising in the corporate bond market. Rising corporate debt levels and stretched valuations leave little room for error.
International developed market bonds offer little value beyond diversification. Very low or negative yields make total return prospects relatively low for U.S. dollar-based investors.
The dollar should remain firm, but further upside will depend on continued outperformance by the U.S. economy relative to other major countries.
Temper return expectations. After a strong year for fixed income returns in 2019, total returns in 2020 are likely to moderate.
Bond investors have enjoyed strong returns in 2019. The steep drop in yields and declining credit spreads (the yield difference between corporate bonds and Treasuries of the same maturity) combined to boost returns in a wide range of fixed income asset classes. In 2020, we expect returns to be more subdued. From current levels, yields are likely to move modestly higher, while there isn’t much room for credit spreads to fall further. Consequently, we expect returns to be in line with the current income offered on bonds, while price gains are likely to be limited.
Fixed income total returns, year to date
Source: Bloomberg. Returns from 12/31/2018 through 11/29/2019. Indexes representing the investment types are: US Aggregate = Bloomberg Barclays U.S. Aggregate Index; Short-term core = Bloomberg Barclays U.S. Aggregate 1-3 Years Bond Index; Intermediate-term core = Bloomberg Barclays U.S. Aggregate 5-7 Years Bond Index; Long-term core = Bloomberg Barclays U.S. Aggregate 10+ Years Bond Index; Treasuries = Bloomberg Barclays U.S. Treasury Index; TIPs = Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index; Agencies = Bloomberg Barclays U.S. Agency Bond Index; Securitized = Bloomberg Barclays US Securitized Bond Index; Municipals = Bloomberg Barclays US Municipal Bond Index; IG Corporates = Bloomberg Barclays U.S. Corporate Bond Index; HY Corporates = Bloomberg Barclays US High Yield Very Liquid (VLI) Index; IG Floaters = Bloomberg Barclays US Floating-Rate Notes Index; Bank loans = S&P/LSTA US Leveraged Loan 100 Index; Preferreds = ICE BofA Merrill Lynch Fixed Rate Preferred Securities Index; Int. developed (x-US) = Bloomberg Barclays Global Aggregate ex-USD Bond Index; EM USD = Bloomberg Barclays Emerging Markets USD Aggregate Bond Index. Returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
A bounce in yields as recession fears ease
Waning recession fears should tip the scales toward higher 10-year Treasury yields in 2020. One of the key drivers behind the steep drop in yields in 2019 was fear of a recession, as manufacturing activity fell and tariffs weighed on the growth outlook. However, rate cuts by the Federal Reserve have helped ease those concerns. In 2020, the lagged impact of the Fed’s interest rate cuts, signs of stabilization in the global economy, and a modest uptick in inflation expectations should provide a boost to bond yields. We don’t expect a big rise in economic growth, but even at a gross domestic product growth rate of about 2%, there is still room for bond yields to move modestly higher.
The risk to our outlook is the potential for trade conflicts to heat up further, weighing on business investment and growth. While a “no deal” outcome to U.S.-China trade talks would likely limit upside growth potential, it wouldn’t represent a change from the status quo. However, increased tariffs or a widening of the trade conflict to other trading partners would limit the potential for yields to rise. Therefore, we are expecting 10-year Treasury yields to move up to the 2.25% to 2.50% region, with the major caveat that a worsening trade outlook could result in yields remaining below 2%. Barring a recession, the chances of a drop back below the 2019 low of 1.52% are diminishing.
Federal Reserve policy: Easy does it
The Federal Reserve has made it clear that after three 0.25% rate cuts in 2019, bringing the federal funds rate to a range of 1.50% to 1.75%, monetary policy is on hold for the foreseeable future. With the yield curve “un-inverted” and the real fed funds rate—that is, adjusted for inflation—in negative territory, recession fears should abate. The policy rate should be low enough to provide stimulus to the economy, keep credit flowing to businesses and consumers, and raise inflation expectations from very low levels. The Fed is also reportedly considering a policy of allowing inflation to hold above 2% without countering it in order to cement positive inflation expectations.
Rates usually steepen ahead of a rate cut cycle
In some cases, rates began to steepen ahead of the first rate cut cycle, but subsequently fell in anticipation of the first rate cut.
Source: Effective Federal Funds Rate, (FEDFUNDS) and 10-Year Treasury Constant Maturity Rate, Percent, Monthly, Not Seasonally Adjusted (DGS10). Data as of 12/2/2019. The shaded areas indicate the first time the Fed cut rates in each rate cutting cycle. Past performance is no guarantee of future results.
The Fed’s policy stance has also kept financial conditions very easy, countering recession risk. Historically, a yield curve inversion has been a reliable leading indicator of recession in the following 12 to 18 months. However, the trigger for recession has often been a tightening in credit conditions that followed an inverted yield curve. Borrowers had difficulty getting access to funds as banks tightened credit standards and raised lending rates. That hasn’t happened this time around. While recession models based on the yield curve were flashing warning signs last spring, the credit markets were not, making us doubt there would be a recession in 2019. It’s notable that even during the period of Fed tightening in this expansion, companies and consumers had access to ample amounts of credit on easy terms. Now that the yield curve is positively sloped and credit spreads are low, the markets’ concerns about an imminent recession should diminish.
Inversion of the 10-year/3-month Treasury spread can predict the probability of recession 12 months ahead
Twelve Months Ahead (month averages)
Source: New York Federal Reserve. Monthly data as of 10/31/2019. Shaded bars represent recessions.
Notes: This model uses the slope of the yield curve, or “term spread,” to calculate the probability of a recession in the United States twelve months ahead 10/1/2020. Here, the term spread is defined as the difference between 10-year and 3-month Treasury rates.
Corporate credit yield spreads over Treasuries also can be a predictor of recession
Source: New York Federal Reserve. Monthly data as of 10/31/2019. Gray bars represent recessions.
As we look into 2020, conditions for positive economic growth are still in place. Fed policy is accommodative and capital is widely available on easy conditions.
Global slowdown nearing an end?
A rebound in the global economy in 2020 could also contribute to a modest rise in bond yields. Growth forecasts are still soft in most regions, but the worst-case scenario of a global recession doesn’t appear likely. Leading indicators of global growth, which declined in a synchronized pattern over the past two years, have begun to stabilize and rebound. It’s the third time in this long expansion that the indicators dropped. In the previous two occurrences growth rebounded. However, the recent drop was the deepest and most synchronized among the world’s largest economies, raising fears of a global recession, which was reflected in the steep drop in bond yields. However, aggressive central bank easing in Europe and the U.S., and fiscal stimulus in China, have helped keep recession at bay. Leading indicators for China and Europe have begun to stabilize or turn higher, signaling that the worst may be over. If the tentative signs of a rebound prove durable, bond yields could rise globally from extremely depressed levels.
OECD Composite Leading Indicators show slowing growth in developed economies
Note: The Organisation for Economic Co-operation and Development’s (OECD) work is based on continued monitoring of events in member countries as well as outside OECD area, and includes regular projections of short and medium-term economic developments. Shaded areas indicate time periods where CLI's were below the long-term average 100.
Source: OECD as of September 2019.
Inflation expectations need a boost
Inflation expectations are the key to higher yields on intermediate to long-term bonds. Various measures of inflation expectations have remained low despite a tight labor market, rising wages, and healthy consumer spending. The implied inflation rate embedded in the Treasury markets and survey-based measures like the University of Michigan Consumer Sentiment Index indicate investors and consumers expect inflation to remain persistently low. The 5-year/5-year inflation swap rate, a proxy for market-based inflation expectations, hit its lowest level since 2016 in mid-year, but has since rebounded to about 1.75%.
5-year/5-year Forward Inflation Expectation Rate
Notes: A measure of the average expected inflation over the five-year period that begins five years from the date data are reported. The rates are comprised of Generic United States Breakeven forward rates: nominal forward 5 years minus US inflation-linked bonds forward 5 years.
Source: Bloomberg 5-year 5-year Forward Inflation Expectation Rate (USGG5Y5Y Index). Daily data as of 12/2/2019.
However, actual readings of inflation are higher and rising. Looking at eight different inflation measures used by or created by the Federal Reserve, more than half are at or above the Fed’s 2% inflation target. With the economy showing resilience and core inflation edging higher, there is room for higher inflation expectations.
The year-over-year percentage change in some inflation measures is at or above the Fed’s 2% inflation target
Source: Federal Reserve Bank of St. Louis, Bloomberg. Consumer Price Index for All Urban Consumers: All Items (Overall CPI), U.S. Personal Consumption Expenditure Core Price Index (Core PCE), Monthly data as of 10/31/2019.
U.S. Personal Consumption Expenditure Deflator (PCE Deflator), Consumer Price Index for All Urban Consumers: All Items Less Food and Energy (Core CPI), 16% Trimmed-Mean Consumer Price Index % change at annual rate (FRBC Trimmed-Mean CPI), Sticky Price Consumer Price Index (FRBA Sticky Price CPI), Median Consumer Price Index % change at annual rate (FRBC Median CPI), Sticky Price Consumer Price Index, Less Food and Energy (FRBA Sticky Price CPI Core).
By our estimates, a stronger growth outlook and rising inflation expectations could add as much as 50 to 75 basis points¹ to 10-year Treasury yields, bringing them up to the 2.25% to 2.50% level. Yields would still be low at those levels, but would be more consistent with a moderate growth outlook.
We suggest investors consider adding a small allocation of Treasury Inflation Protected Securities (TIPS) to portfolios, since breakeven rates are below the Fed’s 2% target, which makes the inflation protection that TIPS offer relatively inexpensive. We also suggest using bond ladders, adding to duration if yields move up to the 2.25% to 2.5%. Yields above 2.5% are unlikely in our view, since it would likely require much stronger global growth and higher inflation than we anticipate.
International bonds/dollar outlook: Not much to see here
With low to negative yields in many markets and a firm dollar, the risk/reward in international bonds does not look attractive for U.S. investors. We expect the dollar to remain in its long-term bull market but further upside will depend on continued outperformance by the U.S. economy relative to other major countries.
The dollar has been in a long-term bull market
Source: Bloomberg, using daily data as of 12/3/2019. Bloomberg Dollar Spot Index (BBDXY Index).
While good for diversification, the negative carry (that is, when the cost of holding an investment is greater than the income earned from it) and currency risk associated with international bonds reduces their appeal. Emerging market (EM) bonds don’t offer enough yield spread above U.S. Treasuries to be attractive either. Demand has been strong for U.S. dollar-denominated EM bonds as investors search for yield, but valuations are high. At about 350 basis points over Treasuries, EM bond spreads are near the lower end of the historical range. A strong dollar tends to be a negative for EM bonds, especially since the issuance of U.S. dollar-denominated debt has soared since the 2008 financial crisis.
U.S. yields are above yields in other major countries
Source: Bloomberg. Data as of 12/3/2019. Past performance is no guarantee of future results.
Credit markets: Something’s got to give
The sharp drop in yields in 2019 led investors reach for yield across the fixed income universe. As a result of this search for yield, valuations in the more aggressive segments of the fixed income markets have become stretched. Credit spreads have fallen to very low levels even as corporations have taken advantage of low yields to boost debt levels on their balance sheets. While borrowing when rates are very low is rational, the added debt burden raises the risk of downgrades and defaults if profit growth slows down. The risk is heightened for bonds in the lowest credit tiers, such as high yield bonds. Given rich valuations, we see higher risk of price volatility and even price declines. Income payments are likely to drive total returns for most corporate bond investments in 2020, and it’s unlikely that next year’s performance is as strong as 2019’s total returns.(Please see our upcoming 2020 Outlook for the corporate bond market.)
Municipal bonds: Valuations have improved
One market where valuations have improved is the municipal bond market. The yields offered on tax-exempt muni bonds compared to Treasuries of comparable maturities have moved up from the lows of early last year. For maturities of five to eight years, yields are back to levels that are consistent with the long-term trend. The supply/demand outlook is also looking positive for municipal bonds. Net issuance is likely to decline, while demand remains strong, especially in high-tax states where the 2017 tax reform capped deductions for state and local taxes (please see our upcoming 2020 Municipal Bond Outlook).
Strategy for the new year
- Consider adding duration to fixed income portfolios if 10-year Treasury yields move up to the 2.25% to 2.50% region or as part of a long-term ladder strategy.
- TIPS appear relatively attractive. Breakeven inflation rates are below long-term averages and the Fed’s 2% target, so the cost of inflation protection is relatively low.
- Underweight high-yield bonds. The yield advantage that high-yield bonds offer relative to Treasuries is low, while corporate profits are likely to be challenged in 2020. Investment grade corporate bond investors should also move up in quality, focusing on bonds with “A” ratings or above.
- Consider higher-rated municipal bonds in the five to eight-year part of the yield curve. Net supply is likely to remain low, keeping prices from falling much.
- Stay local. With low and negative yields across the globe, international bonds provide diversification benefits—but not much else.
- Be realistic about returns. After outsized gains in 2019, returns for fixed income investors are likely to be more subdued in 2020.
Conclusion: Tipping toward higher yields while limiting risk
We expect 2020 to present an opportunity for investors to earn higher yields on their fixed income investments. Prospects for improving growth and higher inflation should lift yields from the depressed levels of 2019. A good entry point for adding duration would be when 10-year Treasury yields move up to the 2.25% to 2.50% region.
Despite signs of economic stabilization, we are concerned about rising risks in the more aggressive parts of the bond markets, like high-yield bonds, bank loans, and emerging market bonds. We suggest reducing exposure to high-yield bonds, while moving up in quality in the investment grade market. Municipal bond valuations have improved from early 2019 levels and still appear attractive for investors in higher tax brackets.
¹ A basis point is equal to 1/100th of one percent, or 0.01%. Fifty basis points is equal to 0.50%.
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