Fixed-income Outlook

U.S. Yield Curve 10-year Treasury Yield Minus 3-month Treasury Bill Yield chart

Source: FactSet, 12/31/2018..

Continued economic expansion supports our view that equities will outperform bonds as interest rates rise slightly. However, the return of sustained market volatility highlights the importance of including fixed-income assets in your portfolio during the late stages of the bull market.

Flat yield curve signals modest growth – As both short-term and long-term rates increase slowly, the gap between them, known as the yield curve, has flattened, as shown in the chart above. When the yield curve is flat, short-term bonds provide a rate that is close to long-term bonds without the additional interest rate risk. Historically, flat yield curves have been consistent with modest economic growth, while slightly higher rates imply lower fixed-income returns. However, slower growth and a return of normal volatility highlight the important role bonds play in helping reduce portfolio risk. Since it’s impossible to predict future interest rates, owning a laddered bond portfolio with staggered maturities helps cushion market swings whether rates move up or down.

Fed to be patient and flexible – A key source of market volatility is investor concern that inflation will increase more than currently anticipated, leading the Federal Reserve to overtighten and slow economic activity or, even worse, trigger a recession. Though this is a risk, inflation is still quite moderate, and we are not expecting a spike in consumer or producer prices anytime soon. We also expect Fed policy to be flexible and responsive to changes in the economy, and to likely pause rate increases over the course of the year. In our view, the Fed’s gradual approach to rate hikes will likely extend the current bull market.

Action for investors

With rates continuing to edge higher, we remain cautious about long-term bonds and recommend that they represent no more than 15% of fixed-income portfolios. If you are overweight in long-term bonds, consider adding short and intermediate maturities to take advantage of the flat yield curve and to reduce the impact that rising rates can have on your portfolio.

Important Information:

Investors should evaluate whether a bond ladder and the securities held within it are consistent with their investment objectives, risk tolerance and financial circumstances.

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