Bond investors were understandably nervous entering 2017. The market had just come off a significant post-election selloff as interest rates rose sharply across the yield curve. Growth and inflation expectations were increasing and many market commentators prognosticated that rates were destined to keep rising and bond prices were destined to keep falling. Our view was a bit more nuanced, however, as was highlighted by a key passage from our January market outlook:
Could rates move higher during certain periods of 2017? Sure. Will the bond market enter a sustained bear market where yields correct sharply to the upside? Unlikely. And even if rates do move higher over the course of the year, bond investors can still make a positive return with relatively low levels of volatility because of the income generation bonds provide.
As we enter the second half of 2017, this view has held. Bond market returns have been positive and volatility has been low, making risk adjusted returns look quite strong. Our thesis was, and continues to be, driven by four key factors: fiscal policy implementation is hard, inflation is likely to be constrained, low yields overseas make U.S. bonds look attractive, and risk asset volatility could crop up at any time.
The economic growth bump that was expected to come from fiscal policy easing has yet to materialize, and appears to have been delayed until 2018, if not indefinitely. Tax reform and infrastructure spending, which were expected to be the main incremental growth drivers, have been pushed to the back burner while healthcare reform is debated. And as Congress returns from its July 4th recess, it will need to turn its attention to the upcoming debt ceiling. The IMF last week lowered its 2017 and 2018 U.S. GDP forecasts to reflect these policy challenges, and summarized the current state of affairs as follows: “Even with an ideal constellation of pro-growth policies, the potential growth dividend is likely to be less than that projected in the budget and will take longer to materialize.” We couldn’t agree more.
Inflation has also disappointed versus expectations, and remains a far cry from the Federal Reserve’s 2% objective. Interestingly, the weakness in inflation is being driven not only by the decline in energy prices, but also by an area that has until recently been one of the main sources of inflation in recent years, owners’ equivalent rent (OER). The law of supply and demand usually wins out, and the large supply of housing units that have come on line in recent years is depressing rental prices. Housing costs represent nearly a third of the consumer price index, making a slowdown here ripple throughout the index. This, coupled with a lack of significant wage growth, has made it difficult to find an area that will drive inflation higher.
Globally, interest rates remain low and are providing support for U.S. bonds. When compared to 10-year U.S. Treasury Notes, 10-year German Bunds and 10-year Japanese Government Bonds remain near historic lows. This attractiveness has helped generate inflows into the U.S. bond market from foreign investors. Through April, foreigners have purchased nearly $35 billion of U.S. bonds this year, a trend we don’t expect to reverse in the near term.
And while market volatility has remained at historically low levels thus far in 2017, there are plenty of potential hot spots that could cause volatility to spike, which would also create a safe haven bid for high quality U.S bonds.
Our outlook is predicated on the thesis that the current environment provides a sweet spot for investment grade bond investors. The Federal Reserve is normalizing monetary policy, which is lifting short-term rates off the zero bound and providing income for short-term bond holdings. At the same time, the four key factors we detailed above should continue to keep longer-term rates range bound, which provides support for long-term bond prices. So, is the bull market in bonds over? The answer continues to be no, and instead of thinking about bonds in a bull or bear market, we encourage our clients to think about high quality bonds for what they are, a low volatility asset class that can provide a continuous stream of income for years. As always, please let us know if you have any questions or comments.
Source: IMF, US Treasury, JP Morgan
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