The global economic environment is improving. Growth is running modestly above trend across many countries and regions, a phenomenon that has not occurred in many years. We have to look to periods before the global financial crisis of 2007-08 to find an expansion this broad-based. However, fixed income markets may be too optimistic that these favorable conditions can continue for an extended period.
In our view, the global economy must continue to operate in this narrow band of "just right" to support current credit market valuations that remain elevated. Should growth momentum accelerate and break out above recent ranges, this would likely trigger more aggressive policy responses by global central banks. The resulting tighter monetary policy, delivered via higher policy rates and a faster withdrawal from quantitative easing, would likely hamper growth.
We expect U.S. interest rates to remain range-bound with the 10-Year Treasury yield hovering in the range of 2.25% to 3%.
Even as they tighten monetary policy, the bias of central banks remains supportive of economic growth.
With inflation muted and growth rates modest, we expect the Fed will take a gradualist approach.
Municipal bonds continue to offer tax-advantaged income and diversification potential, but total return potential is likely to moderate and volatility could rise.
Long-term interest rates in the U.S. and much of the developed world remain at low levels. In the U.S., a number of factors have kept yields low, such as modest economic growth, persistently low inflation and strong demand from global investors for U.S. bonds. Long-term rates could rise modestly as U.S. economic growth remains robust and the Fed has started to trim its balance sheet, which means it will no longer be the largest buyer of bonds. Capital Group’s fixed income team expects the benchmark U.S. 10-Year Treasury yield to remain in a 2.25% to 3% range even though policy-driven rates are rising.
Despite the low level of yields on a historical basis, U.S. interest rates remain higher than many other developed markets, partly because the U.S. economy has sustained a significantly higher growth rate. The higher yields in the U.S. relative to other developed markets should continue to support demand for U.S. Treasuries. Meanwhile, against the backdrop of low interest rates in developed economies, demand for higher yielding emerging markets debt has risen substantially. The fixed income team expects this demand to continue.
Since the financial crisis, central banks have expanded their balance sheets to unprecedented levels. These banks became the largest buyers of bonds and other securities as a way of increasing money supply to boost struggling economies. The four major central banks increased securities held on their books from around $4 trillion in 2007 to about $15 trillion in 2017. Now, as the global economy improves, some of them are beginning to move in the other direction. The Fed began shrinking its balance sheet in October. The European Central Bank signaled it will begin to trim its purchases of securities starting in January. With the Fed stepping away from its role as the largest buyer of securities, the risk of a modest rise in yields cannot be ruled out.
As the Fed continues on a path of gradually raising interest rates, many investors are moving to cash, short-term bonds and floating-rate securities. But the view that bonds have to suffer losses when short-term rates rise is a misconception. Looking at the past seven periods of interest rate hikes, including the current period, investment-grade bonds (BBB/Baa and above) have generally delivered positive returns, as can be seen from results for the Bloomberg Barclays U.S. Aggregate Index.
If rate hikes are gradual, interest earned by bonds can overcome the price impact to deliver a positive return. Indeed, since the Fed began on its current course of rate hikes, the index has gained nearly 6%, even as the Fed funds target has risen by 100 basis points. The Fed has signaled that it will maintain a gradual pace in raising rates and tightening monetary policy. Against this backdrop, interest rates will likely remain range bound.
Municipal bonds are sometimes viewed as vulnerable amid rising interest rates. And yet, the past two years have shown that the asset class can provide solid returns when rate increases are modest and gradual - an environment that appears likely to persist. Also, demand for tax-advantaged income is unlikely to diminish. That said, valuations have been elevated. Greater emphasis on bonds of higher credit quality is one way investors can prepare for more mixed market conditions.
The asset class offers diverse income opportunities across sectors. For instance, toll roads are an area where research can uncover value by assessing prospects in a way that reflect risks associated with financing, operation and the regional economy. Consolidation among not-for-profit hospitals is creating great return potential. Look out for opportunities if uncertainty around the future of tax and health care reform prompts volatility and creates favorable entry points.