MARKET COMMENTARY

Fixed Income Outlook

Rising rates and new government policies will impact the bond market in 2017.

12.23.2016 - Jeffrey S. MacDonald, CFA

KEY TAKEAWAYS
  1. Rates are likely headed higher
    As economic fundamentals improve, we expect the Fed to move gradually in the direction of higher rates. Reflationary fiscal policy in Washington could pressure inflation expectations higher, leading to higher yields for longer-maturity bonds and a steeper yield curve. Other developed markets may follow. 
  2. Duration discipline could be rewarded
    Short-term bonds offer a distinct advantage when rates are rising: They are less price-sensitive when rates rise and, as they mature, proceeds can be reinvested at higher rates. 
  3. Presidential policies will influence the market
    Tax cuts could strengthen fundamentals in the corporate bond market, while infrastructure projects could help drive supply for new municipal bonds.

View Our Full 2017 OUTLOOK


In the US, expectations for rising rates and the new president’s pro-growth policies could have broad implications across the fixed income universe.

Monetary policy has dominated the global economy since the financial crisis. But central bankers and legislators alike are beginning to acknowledge the fact that monetary policy has been stretched to the limits of its effectiveness. In economies that are growing, such as the US, some argue that the risks associated with persistently low rates now outweigh any benefits they offer.

As the limitations of accommodative monetary policy become clearer, elected officials have been warming up to the idea of adjusting their fiscal policies to support central bank monetary policies. In other words, they are hoping that lower taxes and more generous government spending on large capital improvement projects, combined with relatively low interest rates, will move the economic needle in a significant way.

This new level of support for government spending represents a significant departure for legislators, many of whom advocated budget constraints and strict austerity measures in the aftermath of the global financial crisis.

A Change in the Direction of Interest Rates

In 2016, some investors were so confident that central banks would continue to push policy rates lower that many invested in the bond market purely for capital appreciation opportunities, expecting yields to continue falling and prices to increase proportionately.

This investment thesis was fairly successful in 2016, as strong demand in the bond market contributed to unusually strong price appreciation, at one point driving approximately $14 trillion worth of the global bond market into negative yield territory. But this tactic is less likely to work in 2017, in our opinion, as government spending picks up and policymakers feel less pressure to keep interest rates near zero.

In the US, where employment has been relatively strong and inflation expectations have been rising, we expect the Fed to move cautiously in the direction of higher rates in 2017 and beyond. The pace and magnitude of any increases are difficult to predict because they depend heavily on economic data and policy changes in Washington. But rising wages, inflation, tax cuts and more government borrowing at the federal level to finance infrastructure projects mean we are likely moving in the direction of higher rates.

We will be watching closely as the Fed tries to maintain the delicate balance between promoting economic growth and keeping inflation in check. In countries throughout Europe, where economic growth is still challenged by high levels of unemployment and stagnant GDP growth, we expect policymakers to maintain rates at their historically low levels throughout the year, and possibly longer.

Reaping the Rewards of Shorter Maturities

Throughout 2016, we cautioned investors against stretching for yield in longer-dated bonds in a fully valued marketplace. We believe that investors who maintained this disciplined approach to income investing are likely to be rewarded in 2017, as the outlook for higher rates in coming months has improved. As short-term bonds mature, capital can be reinvested at higher prevailing rates.

We expect the US yield curve to steepen in the near term, with yields on longer-maturity bonds rising faster than shorter-maturity bonds, as the market adjusts to a policy platform in Washington that could likely result in accelerating levels of inflation. Yields on longer-term bonds are driven by inflation expectations, while yields on shorter-term bonds are influenced primarily by central bank policy.

Suddenly, New Income Opportunities

As we approached the elections in November, inflation expectations and bond yields were beginning to gradually rise. The election of Donald Trump as our nation’s 45th president has pushed those expectations even higher, as investors look forward to the tax reforms, deregulation and fiscal stimulus programs he championed on the campaign trail.

How will this new environment of rising inflation and higher rates impact the bond market? In the municipal bond market, issuance levels could be helped by local governments partnering with the federal government to modernize highways, bridges, railroads and other parts of the nation’s transportation infrastructure. This, combined with higher rates, could expand the universe of attractive investment opportunities for tax-advantaged income.

We expect credit quality in the muni market to remain relatively high and defaults to remain relatively low throughout the year. But careful credit analysis is still the cornerstone of our portfolio construction process.


This communication is intended solely to provide general information. The information and opinions stated are as of December 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

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