Interest rates shot up in January to their highest level since 2014 as the market celebrated strong economic growth and the potential for added economic stimulus from President Trump’s tax cuts.
X The yield on the 10-year Treasury note surged 32 basis points to end the month at 2.72%. Meanwhile, riskier credit sectors saw their average spreads — their yield differential against a similar-maturity Treasury bond — shrink to the lowest levels since before the Great Recession of 2007-08.
“January has been a pretty exceptional month for fixed income,” said Steve Bartolini, portfolio manager of T. Rowe Price Inflation Protected Bond (PRIPX) and T. Rowe Price Limited Duration Inflation Focused Bond (TRBFX), and co-portfolio manager of the U.S. Core Bond Strategy, including T. Rowe Price New Income (PRCIX). He noted that the rate surge and strong excess return of the credit markets “just accelerated the trends that were in place in the fourth quarter of 2017.”
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The average domestic taxable bond fund rose 0.05% in the January and 0.41% in the past three months.
International markets were once again the big winners on the month, with emerging market local and hard-currency bond funds surging 3.85% and 0.97%, respectively, as the dollar continued to weaken in January. International income funds also did well, returning 1.99%.
“The world growth is in sync for the first time in many years,” said Jeffrey Gundlach, CEO of DoubleLine, in a recent webcast. He pointed out that every single country, even Brazil, which had been in a steep recession, has turned to positive growth.
On the domestic front, high yield and loan participation funds each advanced 0.63% and 0.91%. Investment-grade credit did not do as well, shedding 1.05% and 0.81%, respectively, for the A and BBB rated funds.
General U.S. Treasury funds posted the steepest declines, sinking 2.21%. Short U.S. Treasury ones gave up 0.43%, while Treasury inflation-protected securities funds fell 0.5%. Municipal bond funds declined an average of 0.84%.
By comparison, U.S. diversified equity funds sprang 4.37% last month.
Outlook For Interest Rates And Bonds
In addition to the tax bill, “the broad sentiment has shifted to pretty much everyone recognizing that global growth is strong and synchronized, and that central banks have some leeway here to remove accommodation in the case of the ECB, and maybe even the BOJ (Bank of Japan), and the Fed to continue to tighten,” T. Rowe Price’s Bartolini explained.
Last Wednesday marked the last Fed meeting for Janet Yellen, who, as expected, left rates unchanged. On Feb. 5, Jerome Powell is taking over the reins of the Federal Reserve in what is expected to be the same slow-paced rate policy as Yellen’s. As it stands now, U.S. markets currently assign a near-certainty for a Fed rate hike in March, over 60% chance for another one in June and 30% for September.
“We expect the Fed to hike three times in 2018, which is essentially what the market is pricing in,” said Paul Jakubowski, global head of credit at Vanguard. “It’s been people’s expectations that inflation is going to move up and it’s been reflected in a variety of markets. We’ve seen the unemployment rate continue to stay low at 4.4% and we added another 150,000 jobs in the U.S. in January, and we also had tax reform. … What that really did is remove a lot of uncertainty in the market about was it going to get done and what was it going to look like.”
Jakubowski says that the overarching theme for fixed income investors is that cost matters now more than ever because of the low level of yields based on history “and I think that should really be focused on: that your fees are really chewing into a lot of your return.”
He still likes high yield but has moved up in quality to B and BB rated credits. He’s also constructive on high-quality structured products such as asset-backed and commercial mortgage-backed securities. Within the investment-grade corporate space, he favors financials vs. industrials, select REITs and he is fairly positive on the energy markets with the recent rally in oil.
In the tax-free universe, municipal bonds saw a lot of cash inflow in December, but this trend has slowed in January. “With the reflation trade and rates going higher, we’ve seen negative returns in the long end of the muni curve, but it’s still a very good source of yield in a diversified portfolio, not just from a tax perspective but also from another sector that’s very high quality,” said Vanguard’s Jakubowski.
T. Rowe Price’s Bartolini says he’s overweight TIPS. They fairly valued, but “we do feel like there is more upside potential on underlying inflation.”
Internationally, he sees pockets of value on the European periphery, such as Spain. He also likes Brazil, but is less constructive on Mexico due to political risks.
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