The end of the year is upon us, which means it’s time for some big-picture thinking on the bond market. I’m never wedded to my year-ahead views, but they serve as a road map and keep me aware of where things change and where I’m wrong. With that, here are the highlights.
The Federal Reserve just raised its main interest rate to 1.5%, and the market is pricing in a rate just above 1.87% by the end of 2018, with a 30% chance of 2% to 2.25%. I give more odds to the latter, especially if some of the Fed’s alternative views on inflation influence policy. A recent San Francisco Fed report titled “What’s Down With Inflation?” says pro-cyclical inflation is at pre-recession levels while a-cyclical ones are temporary, such as lower Medicare and health care costs.
Overall growth to remain modest, along the 2.1% lines that have been the average since 2012. The Republican tax plan might help, but I’m just not sure if that’s 2018 or 2019. The expansion has been a long one, and there are some late-cycle elements that make me more cautious. Base effects could lift inflation early in the year, maybe aided by oil, commodities and the dollar. I don’t think it will last, but it gives the Fed cover.
I hate being in the consensus, but with Fed transparency and the Treasury’s borrowing plans, there’s reason to expect upward pressure on the front end of the yield curve. And I do think 10-year Treasury yields can probe the post-election high near 2.64% and perhaps take a stab at the 2.75% to 2.90% range. If that happens, then I would deem it a buying opportunity, pulling yields back down into the 2.20% to 2.50% range in the second half of the year.
2. The Yield Curve
The bull market in bonds may be over, but I don’t believe we’ve entered a major bear market. The budget deficit was going to rise sharply before the consequences of the tax plan. The Treasury wants the increase in debt-financing to be concentrated in shorter maturities, which along with Fed rate hikes means more pressure on the front end relative to the back end of the yield curve, flatting it even more.
While the Treasury has backed away from adding longer-term debt, I don’t believe that can last.
First, all issuance will have to rise as the deficit expands.
Second, the logic of a flatter curve, with rates still low, makes a compelling case for more 30-year bonds and the introduction of maybe 40-and 50-year bonds. This isn’t a 2018 issue, but the debate will go on and I think becomes serious later in the year. There’s rising risk that the Republicans lose a lot of seats in the midterm elections, raising uncertainty.
The GOP tax plan is not reform but deficit-financed tax cuts; the GDP impact remains to be seen. The Joint Committee on Taxation says it will increase GDP by just 0.8% over 10 years in total. Further, while it’s good for corporations and the wealthy, it will be neutral for many and downright negative for those in high-tax states. This plan is not exactly popular with the electorate, with only a 25% to 29% approval rating.
With central banks taking away the proverbial punch bowls, equity markets at record highs, credit spreads taut, and, yes, things like bitcoin reeking of a speculative bubble, I look for, ahem, subdued returns.