It would be easy for bond investors to panic right about now. Interest rates, which move inversely to bond prices, have run up to multiyear highs, and most bond funds are down in the past month—long-term government bond funds most sharply, with a 3% loss. The benchmark 10-year Treasury yield climbed 0.3 percentage point in the past two weeks alone to close Friday at 2.58%.
The Federal Open Market Committee is all but certain to hike rates at the conclusion of its March meeting on Wednesday. The strong February nonfarm payrolls report released Friday—235,000 jobs were created, and unemployment fell to 4.7%—clinches the deal. That meeting includes a press conference and new economic projections, so it's possible Federal Reserve Chair Janet Yellen and company could bump up hawkish expectations.
Possible, but not likely, say bond strategists. "The gradual approach to rate hikes seems to be working quite well," says Kathy Jones, chief fixed-income strategist at Charles Schwab. "If I were Janet Yellen, I'd be quite pleased. So why push it?" It would likely take more positive economic data before the Fed would ratchet up projections that call for three rate hikes this year and next.
Now that rates have run up, that pace of rate hikes is pretty near priced into the markets, says Michael Arone, chief investment strategist at State Street Global Advisors. Expectations for Fed rate hikes have increased rapidly while uncertainty remains high, he notes. Market disruption from European elections, federal budget negotiations, and foreign central-bank policy changes could all create volatility that would give the Fed reason for pause.
Meanwhile, some economic measures are cooling. The Atlanta Federal Reserve's real-time gauge of gross domestic product, known as GDPNow, shows just 1.2% first-quarter growth, down from an estimated 2.5% in late February. Unusually warm weather in February may be a factor in the recent strong job numbers, which could reverse as March weather comes in like a lion.
The big risk for bonds is higher inflation, though it's not a lock. Jim Caron, a fixed-income portfolio manager at Morgan Stanley Investment Management, believes growing labor-force participation could keep wage growth tepid. "If wages aren't moving up as fast, inflation may rise slowly," he says. Oil prices, a key to headline inflation, have fallen sharply in the past week.
The key to market performance near-term will be Trump administration policies, particularly trade, says Jason Celente, senior portfolio manager at Insight Investment. There is potential for investors to be disappointed in policies and the pace of change, which could be reason for stocks to fall and bonds to rally near term. The case for bonds as ballast makes as much sense as ever, he argues.
STRATEGISTS RECOMMEND investors emphasize shorter maturities to protect against rising rates, or consider a "barbell" strategy that includes some longer-term Treasuries that could increase in value if the yield curve flattens in response to rising rates. Corporate bonds and loans, which can benefit from an improving economy, may hold up better than government bonds, which trade based on interest-rate risk.
Longer term, the forecast is for higher rates and gradually rising yields. Rick Rieder, BlackRock's chief investment officer of global fixed income, thinks the Fed may need to hike more aggressively; there could be as many as four rate hikes this year. Still, he argues, that would be positive long-term for investors and the economy.
Either way, investors needn't fear next week's likely Fed rate hike. And while this isn't a time to rush into bonds, holding a cache for income and stability is a smart move as uncertainty remains high.
It would be easy for bond investors to panic right about now.