A rather unsurprising 2017 bond market

Here's the moment of truth for Matt’s predictions—higher interest rates, more inflation—for the 2017 bond market.

Scorecard time! In January I laid out five predictions for 2017’s bond market, but the year ended up being a bit different than what I had expected. Let’s take a look back and see how I fared and where the surprises are.

Prediction #1: Interest rates will likely continue to go up.

I got this one mostly right. The prediction was that the Federal Reserve (Fed) would raise short-term interest rates twice, and it did in March and June. But it’s likely to raise rates again in December, in our view. Even with these hikes, the Fed funds target rate should only reach a range of 1.25%-1.50%, still a fairly modest number. Two-year Treasuries, which are closely tied to the Fed funds rate, rose from 1.19% at the end of last year to 1.75% on November 24 (source: Bloomberg, as of 11/24/2017). Higher, but in line with the Fed moves.

What is really interesting is longer-term rates. Despite the Fed’s actions, we have seen 10-year and 30-year Treasury rates actually decline over the course of the year. Yields of the 10-year note have fallen by 11 basis points and the 30-year note by 30 basis points (source: Bloomberg, as of 11/24/2017). Bond market geeks refer to this as a “flattening of the yield curve,” meaning that shorter-term interest rates rose while longer-term interest rates fell. I had expected that longer-term rates would be held somewhat in check by continued strong overseas demand. I was surprised that longer-term rates didn’t just rise a little—they fell altogether.

Prediction #2: The uncertainty of uncertainty is on the rise.

We entered the year with very low levels of market volatility, both in stocks and in bonds. With a new administration coming into office, and a number of significant potential changes regarding health care and taxes on the docket, my theory was that changing policies would bring about great uncertainty and higher market volatility. That didn’t happen.

Instead, volatility stayed contained. A popular measure of stock market volatility, VIX, was at 14 at the beginning of 2017, and around 12 when I made the prediction. The index did jump up to 16 on a couple of occasions during the year, but right now it sits just below 10 (source: Bloomberg, as of 11/24/2017. For comparison, the VIX has averaged 14.5 over the past five years and 20 over the past 10 years. This year we have mostly remained stuck in a range between 10 and 15. Low volatility is one of the current market’s biggest puzzles—one that we will continue to keep an eye on in 2018.

Prediction #3: Inflation is finally moving up.

Err….no. The expected rate of 10-year inflation has actually fallen from 1.97% at the beginning of the year to 1.87% today (source: Bloomberg, as of 11/24/2017). Investors today expect less future inflation than they did 11 months ago. And realized inflation hasn’t been much better. The Consumer Price Index did reach 2.8% earlier in the year but has since fallen to 2.0% as of the October reading (source Bloomberg as of 11/24/2017).

Bottom line is that both realized and predicted inflation have remained very low. This has contributed to the Fed’s cautious pace of interest rate hikes and helped to keep longer-term bond rates from rising.

Prediction #4: Don’t forget about municipal bonds, despite the headlines.

This one I got right. If you recall, munis were under pressure at the start of the year as some observers were predicting that tax reform could cause some bonds to lose their favorable tax status. While we are still in the midst of the tax debate, it is too early to tell if this will yet come to pass. As of now, it is likely that only a few categories of munis may be impacted.

All in all, municipal bonds performed in line with or ahead of other core asset classes over the course of the year. Through November 24, the S&P National AMT-Free Municipal Bond Total Return Index had returned 4.41%, versus 3.39% for the Bloomberg Barclays US Aggregate Bond Index (source: Bloomberg, as of 11/24/2017). If you were a taxable investor, the muni market return may have been even better after factoring in the potentially favorable treatment on income.

Prediction #5: 2017 will be about yield, not price return.

Got this one right as well. Total returns were muted for most fixed income asset classes thus far this year. The iBoxx USD Liquid High Yield Index returned 6.02% year-to-date through November 24, the iBoxx USD Liquid Investment Grade Index returned 6.38%, and the ICE U.S. Treasury Core Bond Index returned 2.38% (source: Bloomberg, as of 11/24/2017). Across asset classes the story was modest single-digit positive returns. This was a function of the low level of market yields, as well as the low level of volatility and yield movements.

Final score: 2-1-2.

I got two predictions solidly right, two kind-of right, and missed one outright. Not bad for an unusual year, but not quite good enough to elevate me to guru status. Stay tuned—in a few weeks I will take a crack at this again with my 2018 forecast.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

Investing involves risk, including possible loss of principal.

Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

This material does not constitute any specific legal, tax or accounting advice. Please consult with qualified professionals for this type of advice.

There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.

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