Unlike in 2018, when low-duration ETFs were all the rage, this year, investors are willing to take on duration risk, perhaps confident that rates won’t spike too much from here, with growth and inflation relatively tepid.
Gary Stringer, president and CIO of Stringer Asset Management, believes the 10-year Treasury yield will largely be range-bound between 1.75% and 2.25%. Wells Fargo’s Jacobsen also imagines the 10-year yield will be stuck in a trading range, albeit one that is wide and volatile, with an upper bound of 2.5%.
Fed’s Next Move
But the two differ on what the next move from the Fed will be. Stringer, like the market, sees the Central Bank cutting rates to keep the business cycle on track. Jacobsen, on the other hand, thinks the Fed’s next move is much more contingent on how U.S.-China trade talks play out.
“We stick out like a sore thumb from the market in terms of our views,” Jacobsen said. “The market went from pricing in rate hikes to rate cuts rather quickly, and the Fed changed its tone rather quickly. We think the market and the Fed could change their tone back the other way just as quickly.”
According to Jacobsen, the Fed’s projection of needing to cut rates is a conditional forecast. It assumes trade talks will go nowhere between the U.S. and China. If that’s the case, the Fed will likely need to cut rates to help sustain the economic recovery. But if talks are fruitful, especially if President Trump and President Xi can pledge to work together this weekend at the G-20, the outlook for rates could change in a hurry.
“The market view of the likelihood of rate cuts could really quickly turn into a prediction of the Fed holding steady with rates,” Jacobsen said.
Judicious Credit Risk
Regardless of what the Fed does with rates or how trade talks play out, you won’t find many analysts calling for much higher interest rates. Still, with rates having moved down so much and so fast, investors should be careful about taking on too much duration risk, they caution.
“It’s really about trying to take on judicious credit risk as opposed to too much duration risk,” Jacobsen advised. “We’d much rather look at CoCo [contingent convertible] bonds in Europe and select emerging market debt, where you can get a little more yield.”
Meanwhile, Stringer warns investors to stay away from high yield bonds, where he doesn’t think investors are getting compensated enough for taking liquidity and credit risk.
“Within our fixed income positioning, we’re currently favoring short duration and intermediate duration high quality corporate bond and mortgage-backed security ETFs, as well as a taxable municipal bond ETFs on the longer end of the curve,” he said. “Each of these are high quality, liquid, and offer a yield advantage over similar duration Treasury bonds.”