What a difference six months can make. That’s how long it took for the Federal Reserve to go from hiking rates (with talk of more hikes to come) to suggesting it may cut rates imminently.
The turnaround in the 10-year Treasury yield wasn’t any less abrupt. It went from a yield of 3.25% in November to as low as 1.97% this month, propelling the iShares 7-10 Year Treasury Bond ETF (IEF) to its highest level since 2016. (Bond prices rise as yields go down.)
It’s enough to make anyone’s head spin.
U.S. 10-Year Treasury Yield
“It’s been quite an abrupt turnaround. I don’t remember seeing the outlook for monetary policy ever being so volatile,” remarked Brian Jacobsen, senior investment strategist for Wells Fargo Asset Management’s multi-asset client solutions group.
Jacobsen says that the wild ride in the 10-year yield is a direct result of the changing stance of monetary policy, one in which the Fed went from being patient with rate hikes to being prepared to cut rates, all in the span of two quarters.
Rising Recession Fears
Of course, the Fed hasn’t changed its stance in a vacuum. As the stimulus from the Tax Cuts and Jobs Act of 2017 wears off and the U.S.-China trade war acts as a drag, the economy is naturally slowing down.
Professional forecasters expect U.S. economic growth to be closer to 2% this year, down from close to 3% last year. That alone would be enough to send yields lower, but the uncertainty of how the trade war will play out and slowing growth around the world has the “R-word” (recession) popping up a lot more in conversations.
The chance of a recession over the next 12 months is 30%, according to a survey of economists by Bloomberg. Even if they are right, that still leaves a 70% chance of no recession, but the mere hint of the first economic contraction in a decade is understandably spurring safe-haven buying in Treasuries and other investment-grade bonds.
The iShares 20+ Year Treasury Bond ETF (TLT), the iShares Core U.S. Aggregate Bond ETF (AGG), the Vanguard Intermediate-Term Corporate Bond ETF (VCIT) the iShares MBS ETF (MBB) and the Vanguard Total International Bond ETF (BNDX) have all been popular with investors seeking the safety of fixed income this year.
|Ticker||Fund||YTD Flows ($M)|
|VCIT||Vanguard Intermediate-Term Corporate Bond ETF||5,202|
|TLT||iShares 20+ Year Treasury Bond ETF||4,825|
|BNDX||Vanguard Total International Bond ETF||4,482|
|MBB||iShares MBS ETF||4,179|
|AGG||iShares Core U.S. Aggregate Bond ETF||4,160|
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.”