Before Congress passed the tax bill, most economists, strategists and portfolio managers were expecting moderate growth, three Federal Reserve rate hikes and a modest rise in interest rates in 2018, all somewhat negative for bond prices but not critical. The tax bill, which is expected to swell the federal debt by $1 trillion to $1.5 trillion over 10 years, changes those calculations.
It adds 0.25% to 0.50% to annual growth in 2018, along with slightly higher inflation, a likely fourth Fed rate hike, and ultimately higher interest rates, between roughly 2.7% and 3% for the 10-year Treasury by year-end 2018.
(Related: Untimely Fiscal Stimulus Is a Bond Nightmare)
Unemployment is expected to fall below 4%, heading toward 3.5% or lower, which would lift wages and inflation, forcing the Fed into a more aggressive monetary policy, and that is worrying some analysts.
“An overheated labor market puts us at risk for a potential policy mistake,” according to the 2018 Global Market Outlook from Russell Investments. “The Fed could raise interest rates too aggressively, restrict growth and unintentionally start a recession.”
“The new tax bill is likely to provide a short-term bump for activity that the Fed will very carefully take away,” writes Paul Eitelman, investment strategist at Russell Investments.
What to Watch in Bonds
Economists and strategists will be watching to see if the already flatter yield curve inverts, with long-term rates falling below short-term rates, which is an early sign of a recession.
The current spread between the two-year and 10-year Treasury is 59 basis points. It was 2.5 times that a year ago primarily because the Fed had yet to hike rates three more times. The spread is expected to narrow further in 2018 as the Fed hikes rates three to four times, at 25 basis points a pop, and long-term rates increase just 25 to 50 basis points.