The Fed faces a delicate balancing act in 2018. Fixed income portfolio manager David Hoag discusses his interest-rate outlook and implications for investors.
Will McKenna: David, a lot has been happening in fixed income markets in 2017, and of course the Fed's been raising rates. We've seen the beginnings of an unwinding of the various quantitative easing programs; we'll have a new Fed chairman here soon. Give us your outlook for bond markets as we head into 2018.
David Hoag: Sure. So generally, just a few broad themes throughout my portfolios. One is a low-for-longer theme, so while interest rates may slowly drift up, the terminal rate for rates during this cycle I believe to be fairly low. So that's one big theme. And part of what underlies that is [that] fixed income in the United States is still relatively attractive, both globally and locally. So, relative to other developed markets around the world — Japanese 10-year interest rates at effectively zero, German interest rates extremely low, around 40 basis points — 2.4% on a 10-year Treasury is relatively attractive.
And then, more within the United States, if you look at, say, 3-year Treasury rates, we are almost three times higher than the recent low. And so there is actually a little bit of income opportunity back within fixed income. So I think we need to get used to fairly low interest rates. The fixed income markets are generally attractive. There are some areas where valuations are a little stretched surrounding credit, so that would be high-yield and investment-grade corporate bonds and mortgages are all fairly stretched in terms of valuations.
Will McKenna: And that's the search for yield, that —
David Hoag: It's the search for yield, absolutely. As interest rates are low around the world, a lot of investors both within the U.S. and outside the U.S. are looking to our markets as being attractive and really push down the amount one gets paid to take on extra risk, be it through owning companies or through volatility, which is a big component of owning mortgages.
Will McKenna: And is it fair to say, even with the Fed raising rates here, those low rates around the rest of the world will serve as an anchor to keep our rates lower for longer, as you put it?
David Hoag: Yeah, I think so. And so what we've seen during this hiking cycle is the front end of the yield curve — shorter term interest rates — moving up in coordination with what the Fed is doing. The longer end of the yield curve has remained fairly low. And so what's happened over the past year is the yield curve has effectively flattened. And I think that's due to two reasons. One is that need for yield, so buying pressure maintains in the fixed income markets globally. And it's also a view that the Fed won't be able to do as many hikes as a typical cycle would permit. And so the longer end of the yield curve remains anchored in anticipation of a fairly short Fed-hiking cycle.
Will McKenna: What do you see as the path of rate rises from here, and do we have a different view, perhaps, than [consensus] on how many and how high. And then, what does that mean? Is that good for bonds? Bad for bonds? Give us some of that “so what” context.
David Hoag: Sure. Sure. So I'll brush up a little close to bond math here but not get too close. We can actually disentangle what is projected within the markets in terms of what the Fed will do. And it's a case of normalizing policy. At this point, I actually don't see the Fed trying to do what you would historically see at this phase, which is tapping on the brakes. They're still getting to a normalized position, and so this gets them a little closer to that view.
And they're doing this in conjunction with tapering their balance sheet. So they have two sets of brakes that they're using, and they're trying to use them very carefully. So that's currently embedded in the markets. For next year, there are one and a half hikes priced into the math of fixed income. I think that's a fair amount of hikes projected. If anything, they may have to do the full two hikes. So I think, maybe slightly mispriced for next year. And so what leads you to want to do is have a little less interest rate exposure in your portfolios. It's not a meaningful difference, but it's a nuance.
And then in the out years, in '19, there's still a half of a hike suggested in the bond math.
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