The 2018 bond market: This time things are different. Kind of.

Matt sums up his thoughts on the bond market and gives predictions for the year ahead. Which way will the market go?

Hello everyone, and welcome to 2018! The new year is all about New Year’s resolutions, and you can find mine here. The new year is also about making bold predictions for what may lie ahead of us.

A note of caution first. Readers of this blog know that I am a pretty boring investor at heart. My simplified approach is to determine asset allocation based upon investment goals. Then find the most efficient way to build the portfolio, and rebalance regularly to make sure investments are on track. Most importantly, don’t over-trade. Portfolio positioning should be determined by long-term investment goals, not by whatever looks interesting or scary today.

With all that said, every investor should be forward thinking about the markets and consider where things might be headed. Staying informed about the investment landscape is important; it helps in planning for life events and making the needed portfolio changes. To that end, I offer up my five predictions for the bond market in 2018:

1. The Federal Reserve keeps on trucking along.

The current interest rate hike cycle began late 2015, and the Federal Reserve (Fed) has been very transparent in communicating future actions. After one hike in 2015, the Fed followed with another single hike in 2016 before it got going with three hikes in 2017. Based upon the Fed’s guidance, it looks like we are in line for two more rate bumps this year, which would bring the federal funds target rate up to 1.75%-2%. Slow and steady.

2. Inflation is coming but remains mild.

With unemployment staying low and the labor market strong, we are beginning to see these factors push wages higher more consistently. Average hourly earnings were up 2.5% in December 2017, and this could contribute to higher consumer prices down the line (source: Bureau of Labor Statistics). The pickup in wages should be bolstered by the impact of the tax overhaul. But don’t panic: The rise in inflation is likely to be modest. The market is currently pricing in just 2.03% inflation over the next 10 years (source: Bloomberg). Although this figure is on the rise and is likely to continue to increase, it probably won’t spike significantly.

3. The yield curve continues to flatten.

The difference in yield between two-year and 10-year Treasuries recently fell below 50 basis points (source: Bloomberg). Yields on 2-year Treasuries have risen on the back of the Fed moves, but 10-year rates have been held in check by a combination of low inflation and continued actions by global central banks. Although inflation is likely to tick up in 2018, and most central banks are stepping back from their aggressive quantitative easing programs, the changes are probably not enough to cause 10-year rates to move up substantially. Thus the yield curve flattens, as the pace of rising two-year yields has been greater than that of 10-year yields. The big question remains: Will we see two-year rates rise above those of 10-year notes? It’s known as a yield curve inversion and typically a sign of a coming recession. I think this scenario is unlikely in 2018, but it could happen in 2019 if the forces at play continue.

4. Credit spreads are tight, but that doesn’t mean that we are close to a correction.

The amount of extra yield over Treasuries provided by high yield bonds recently was 3.22%, which is the lowest it has been in 10 years and makes some investors cautious. But keep in mind that high yield spreads were below 4% for much of the 2003 to 2007 period, reaching a low of 2.38%. (The source for yield is Bloomberg Barclays). The point being that low spreads can continue for a while.

Now, thoughtful readers will recall that beginning in 2007, spreads widened significantly, peaking during the financial crisis at the end of 2008. This behavior is actually fairly common; when a credit cycle ends, we tend to see yields spike considerably. But that does not appear to be on the horizon in 2018. We can talk again at the end of the year about what 2019 might hold.

5. Once again, yields will drive returns.

Much like in 2017, there isn’t a lot of room for interest rates to fall in 2018, for government or corporate bonds. At the same time, I don’t see any shocks coming that would significantly push rates up. As a result, the majority of bond returns in 2018 will likely come from income, and not from price changes. I hate to have a repeat prediction, but market conditions for 2017 are still very much in place for 2018.

There you have it, insights from my crystal ball for 2018. All that I can really guarantee is that one or more of these will be wrong. Forecasting markets 12 months out is almost an impossible task for anyone. And that is why my points at the top are so important: Let your investment goals be the driver of your portfolio. Good luck in the new year.

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

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.

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