Our outlook for fixed income is based on stable economic growth and a moderate pickup in inflation. Both trends suggest the Federal Reserve will continue gradually increasing short-term interest rates.
Interest rates drift upward – Gradual rate hikes are expected as long as there is solid economic growth and inflation remains near the Fed’s target of 2%. Though still low, U.S. rates are higher than most international developed economies. Hence, U.S. bonds are attractive to foreign investors seeking both higher returns and a safe haven from global market volatility. This demand is likely to keep long-term interest rates below their historical averages.
Flatter yield curve – As short-term rates rise and long-term rates stay low, the gap between the two has narrowed. This gap, known as the yield curve, is the smallest it’s been since 2007. The flatness of today’s yield curve signals expectations for continued modest economic growth, moderate inflation and a gradual withdrawal of Fed stimulus.
An inverted yield curve, in which short-term rates rise above long-term rates, has occurred when the Fed hiked rates aggressively to calm an overheated economy. As the chart shows, an inverted yield curve is a leading indicator of a recession, though not immediately. The time between when the yield curve inverts and the start of an economic downturn has ranged from six months to nearly three years. Inverted yield curves are rare and, in our view, unlikely in the near term.
Fixed-income opportunities – When the yield curve flattens, short-term bonds provide a rate that is close to long-term bonds without the additional interest rate risk. We recommend adding CDs to take advantage of the increase in short-term rates.* Additionally, since it’s impossible to predict future interest rates, holding a mix of long-, intermediate- and short-term bonds helps cushion market swings whether rates move up or down.
Slowly rising rates and policy uncertainties are likely to bring a return to normal market volatility with bigger price movements, both up and down. Make sure you have the right mix of stocks and bonds that matches your comfort with risk. An appropriate allocation to bonds as well as diversification across maturities, sectors and issuers can help provide portfolio protection against future stock market fluctuations and pullbacks. Certificates of deposit (CDs) are federally.
*Certificates of deposit (CDs) are federally insured up to $250,000 (principal and interest accrued but not yet paid) per issuing institution. Please visit fdic.gov or contact your financial advisor for additional information. CD values are subject to interest rate risk such that when interest rates rise, the prices of CDs can decrease. If CDs are sold prior to maturity, the investor can lose principal value. FDIC insurance does not cover losses in market value.
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