Outlook For Fixed Income ETFs

October 11, 2018

[This article appears in our November 2018 issue of ETFR Report.]

 

Fixed-income fever has taken over financial markets again. After a brief lull during the summer months, U.S. Treasury yields are back to hitting new highs, sending reverberations through investors’ portfolios.

As of this writing on Oct. 9, the 10-year Treasury yield had just hit a fresh seven-year high of 3.26%, while the 30-year Treasury yield touched a four-year high of 3.45%.

With Federal Reserve Chairman Jerome Powell recently commenting that the central bank was a “long way” from its neutral policy rate—the interest rate that’s neither restrictive nor stimulative for the economy—investors are wondering whether yields can spike even more from here, and if so, what they should do about it.

 

US 10-Year Treasury Bond Yield

 

Fed Rate Path

One of the keys to determining where rates end up during this cycle is what the Federal Reserve does with its benchmark overnight interest rate, the federal funds rate. The latest Fed dot plot, which contains forecasts for where central bank officials see the trajectory of the fed funds rate, suggests that another hike is nearly certain this December.

After that, the Fed anticipates it’ll hike another three times in 2019, potentially bringing its target rate up from 2-2.25% currently to 3-3.25%—a range many officials believe is close to the neutral rate.

For investors just getting used to higher interest rates, four hikes between now and the end of next year is quite a lot to swallow, but not necessarily hard to justify. The latest economic data has been stellar. The unemployment rate dropped to a 49-year low, and the ISM non-manufacturing index jumped to an all-time high in September.

The booming economy puts pressure on the Fed to continue raising interest rates to prevent accelerating inflation. On the other hand, if, for whatever reason, the economy cools off, the Fed may slow its rate-hiking pace.

Rate hikes are “dependent on continued job growth and inflation. The Fed does not set trends, it follows them,” said Andy Martin, president of 7Twelve Advisors.

The Big Question

While most analysts agree that Fed rate hikes will likely put upward pressure on short-term bond yields, they’re less certain about the long end.

Though 10- and 30-year Treasury bond yields have recently broken out to new multiyear highs, for the year as a whole, they’ve lagged shorter maturities, resulting in a flattening of the yield curve.

For instance, the 10-year yield rallied from 2.4% to 3.2%, or 0.8%, between the start of the year and Oct. 9, but the two-year yield leapt from 1.88% to 2.88%, or 1% in the same period.

 

US 10-Year vs 2-Year Spread

 

 

Investors are concerned that if short-term yields keep rising, long-term yields may not keep pace, resulting in an inverted yield curve, where short maturities yield more than long maturities.

Josh Jenkins, senior portfolio manager and co-director of research for CLS Investments, says whether the yield curve inverts or not is one of the biggest, most important questions facing financial markets.

“We believe the short end is going to continue to move up. The question is, what’s going to happen to the long end?” he asked. “Are our growth and inflation expectations going to pick up and continue to boost the long end? Or are we going to see the inversion?”

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