Fixed-income Outlook

Source: St. Louis Federal Reserve Economic Data

A key component of bond investing this year has been the inverted yield curve, with short-term rates higher than longer-term rates. An inverted yield curve has been a recession warning sign in the U.S. However, despite trade uncertainty and slowing global growth, we don’t think a recession is imminent due to still-positive consumer spending and healthy labor markets. We expect equities to continue to outperform fixed-income investments, with bonds helping to stabilize investor portfolios during normal bouts of volatility.

Central Banks play a central role – The Federal Reserve believes its 2% inflation target is consistent with healthy economic growth. With recent data showing price levels below that target, the Fed has cut benchmark lending rates twice this year to try to stimulate the economy. The European Central Bank has also lowered benchmark rates and announced an open-ended round of aset purchases. With other developed central banks following suit, these policies are likely to prolong the bull market, in our view.

Opening the door to periodic market swings – The Fed has signaled it would cut short-term interest rates to boost demand and reset price levels if inflation tilts lower. But if inflation picks up, we may see the Fed deliver fewer rate cuts than markets expect. The disconnect between markets and the Fed may drive periodic bouts of volatility as investors readjust their expectations.

Bond yields likely to stay low for some time – Though low by historical standards, U.S. interest rates are still higher than most developed countries. For that reason, foreign demand for U.S. Treasuries reached a record high this year, up 7% from a year ago, and has kept long-term rates low, as shown in the chart. Since investment-grade and high-yield corporate bonds are tethered to corporate earnings, we expect default risk to remain low due to still-solid economic and corporate conditions.

Action for investors

With interest rates staying lower for longer, it may be tempting to seek out bonds with the highest yields, but higher yields also signal higher risks. Since we expect more volatility ahead, make sure your bond mix appropriately reflects your comfort with risk. Holding a range of bonds across maturities can help you more easily adjust to unpredictable interest rate fluctuations.

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