Despite indications that the Federal Reserve will likely raise short-term rates before year-end and that its favorite inflation measure will reach the bank’s 2% target by 2019, investors looking to collect more income from bonds should not expect yields will rise much from current levels.
Even the shinkage of the Fed’s reserves to unwind its QE purchases — a program some are calling “QT,” or quantitative tightening — is not expected to increase bond yields much because the wind-down will be gradual.
Nathan Zahm, a senior investment analyst at Vanguard Investment Strategy Institute, recently told Bloomberg News that investors should expect a decade of “muted returns” including 2% to 3% for bonds and 5% to 8% for stocks.
John Lonski, chief economist at Moody’s Capital Markets Research, wrote in a recent commentary that “consumer price inflation lacks both the speed and breadth necessary for a lasting … 10-year Treasury yield of at least 2.5%.”
(Related: New Strategy to Navigate Market Volitility, Sept. 21 webcast with Michael Finke)
The 10-year Treasury is currently yielding about 2.25%, a level too low to pay investors for taking on the additional market risk of a long-term bond compared to short-term securities, according to many strategists.
Referring to that spread, Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, noted at a recent meeting that the term premium for long-term Treasuries, adjusted for inflation, is currently negative.
Lonski, who’s been following the U.S. economy and global bond markets for over 30 years, wrote that the Fed’s favorite inflation indicator, the core PCE price index, “is likely to average something less than 2% annually through 2027, especially if employee compensation cannot sustain a pace faster than 4% annually.”
Wage and salary income rose at an annual rate of 2.6% for the 12 months ended July 2017, which is historically low more than three years into a business cycle upturn, according to Lonski.
In its latest economic projections , the Fed anticipates that core PCE will touch 2% next year and remain there for the long-run, but even that level might be too optimistic, according to Lonski.
It requires “that consumers be able to afford such a steady and broadly distributed climb by prices,” which could be difficult if wage and salary inflation remains low, according to Lonski.
Underlying current and projected levels of low inflation, according to Lonski and Jones, are the growing number of aging baby boomers retiring and being replaced by lower-cost younger workers; globalization, which reduces the pricing power of not only U.S. businesses but also U.S. labor; and technological advances.
Meanwhile, corporations have been taking advantage of low rates, issuing bonds at a record clip. The corporate bond market can withstand the additional volume in the short term because demand is strong, but if issuance continues to grow significantly more than profits, companies could face problems servicing debt long term, especially if the economy falls into recession, said Collin Martin, director, fixed income at the Schwab Center for Financial Research.
Schwab is neutral on most fixed income assets currently. “Nothing looks like a tremendous buy now,” said Jones. “Everything looks expensive.”
— Related on ThinkAdvisor: