So far, 2016 has been a very good year for bond investors. Returns in every major fixed income asset class are up, some quite substantially. Longer-duration bonds have outperformed short-duration bonds, and riskier high-yield bonds have outperformed “core” bonds.1 Even Treasury Inflation-Protected Securities (TIPS) are having a good run—something we haven’t seen in a while.

The problem is that the current combination of trends is unusual, and signals from the bond market are mixed and conflicting. If you’ve done well recently by investing in high-yield and long-term bonds, your portfolio may be in a vulnerable position, because these investments typically don’t outperform at the same time. Long-duration bonds tend to do well when economic growth is slowing and inflation is declining, while riskier bonds tend to do well when the economy is in an upswing. Most long-term bonds are relatively high in credit quality—Treasury bonds and investment-grade corporate and municipal bonds tend to have maturities of 10 years or longer. Riskier bonds tend to have shorter maturities. Meanwhile, TIPS typically do well when inflation and inflation expectations are rising; however, recent data show both indicators are edging lower.

To have these conflicting trends occurring at the same time is strange. There are explanations for why each has occurred, but it’s unlikely they can all continue concurrently for very long. Eventually, something has got to give.

Year-to-date total returns for major fixed income asset classes and the S&P 500® Index

Source: Barclays. Total Returns 12/31/15 to 4/15/2016. Returns assume reinvestment of interest and capital gains.

How we got here
Some of the rally in bonds has been driven by factors outside the U.S. The two top-performing categories have been non-U.S.-dollar-denominated international bonds and emerging market bonds. Both have been boosted by a combination of a 5% drop in recent weeks in the value of U.S. dollar against other major currencies and the European Central Bank’s plan to expand its quantitative easing program. Also, international and emerging market bonds steeply underperformed in 2015, setting the stage for the rebound in 2016.

In the U.S., the main drivers of the rally in the bond market have been the Federal Reserve (Fed)’s downward shift in its projections for the pace of tightening monetary policy and soft U.S. economic data. In terms of the Fed’s outlook, its move to lower its tightening projections shouldn’t have been a shock. After all, the bond market had not bought into the Fed’s projections for the past several years. It was more a case of the Fed catching up to where the market had priced its policy than the other way around. However, it’s worth noting that the downshift by the Fed was more than matched by a downshift in market expectations, even though the factors the Fed pays close attention to when setting policy—unemployment and inflation—are both moving toward the Fed’s projected targets.

Our guess is that the market is giving more weight to the weakening economic data than the other factors. If the Fed should raise short-term interest rates again in June despite a slowing economy, it might only reinforce the perceptions that have caused the market to price in lower long-term interest rates than the Fed has estimated. A flattening yield curve—that is, when the difference between longer-term borrowing costs and short-term borrowing costs grows narrower—typically suggests the market has a pessimistic view of future economic growth.  If softening economic growth prevents the Fed from hiking rates in June, it might signal concerns about a deeper decline causing riskier bonds to underperform.

The Fed’s yield projections have dropped, but market estimates are even lower.

Note: The “forward curve” represents future interest rates implied by the market for interest rate swaps. Source: Federal Reserve Board, 3/16/2015 and Bloomberg Eurodollar Synthetic Rate Forecast Analysis, as of 4/11/2016.

In terms of the economic data, there is a debate going on as to whether the recent weakness is the result of seasonal factors, or whether it represents a downshift in the pace of economic growth. The jury is still out. It has been noted many times that the first quarter historically produces the weakest gross domestic product (GDP) growth figures in any given year, which may be the result of faulty seasonal adjustment factors. However, at the current run rate, first quarter GDP is estimated to be only 0.3%,2 which would mark the second consecutive quarter of very weak growth and the worst economic performance for the U.S. economy in three years. That suggests there is more going on than a statistical error.

Manufacturing activity slows
The industrial sector is contracting and it isn’t just due to the drop in oil prices, although that is a major contributor. U.S. industrial production fell 0.6% in March compared with February—the second consecutive 0.6% month-over-month decline—including a drop in manufacturing output, according to Fed data. Overall industrial production has been in negative territory on a year-over-year basis for the past seven months. Even worse, there were downward revisions to the last two years’ worth of data, showing that the industrial output was much weaker than previously reported. As a result of those downward revisions, capacity utilization now stands at only 74.8%, compared with the previous month’s estimate of 75.3%. That is significantly below the long-term (1972-2015) average of 80%, and well below the 83% level at which capacity constraints have raised inflation pressures in the past.

Industrial production has slowed

Source: St. Louis Federal Reserve.

Moreover, some of the recent weakness in factory output is due to the slowing pace of auto sales, which suggests a slowdown in overall consumer spending. Retail sales dropped 0.3% in March compared with February, according to the U.S. Department of Commerce, which means that first-quarter sales were flat or negative. Excluding gasoline, sales were down 0.4% month over month and up only 3.3% year over year, the smallest increase since 2014. Auto sales, which have declined from an annual pace of 18.1 million units last year to a 16.5-million-unit pace over the past four months, were one of the contributing factors to the decline. Other discretionary spending, such as restaurant dining, has been slowing down as well. Overall, the pace of real retail sales (that is, adjusted for inflation) has been declining for the past six months and is growing at the slowest year-over-year rate since 2013.

Real retail sales growth has been declining

Source: St. Louis Federal Reserve. Real Retail and Food Services (RRSFS) percent change from one year ago, monthly, seasonally adjusted. Shaded areas indicate past recessions. Data as of 3/2016.

With production and consumption slowing down, and capacity utilization low, the recent increase in inflation may prove transitory. TIPS have done well over the past few months because actual inflation has picked up along with the rebound in oil prices and upward trend in rents. Moreover, the market was underpricing inflation late last year.

Despite a recent uptick, the Consumer Price Index has been below 2% since August 2014

Note: The Consumer Price Index measures changes in the price level of consumer goods and services purchased by households. Core CPI is a measure of inflation which excludes certain items that face volatile price movements, notably food and energy. 
Source: Bloomberg, Consumer Price Index for All Urban Consumers: All Items (CPI) and Consumer Price Index for All Urban Consumers: Less Food & Energy (Core CPI).

However, it’s not likely the trend can continue for much longer. Rent increases have already begun to slow down in some markets (notably New York City) and oil prices are likely to stabilize after the sharp rebound from recent lows. It’s notable that inflation expectations are declining as well. According to a University of Michigan consumer sentiment survey released earlier this month, expectations for the inflation rate five years from now have fallen to 2.5%, matching the all-time lows. Fed Chair Janet Yellen has said that she prefers the survey-based indicators over the market-based ones, because she thinks they are more accurate.

The big question on inflation is whether the tightening in the labor market will lead to higher wages and propel demand-pull inflation higher. That’s what the Fed is projecting, but the downturn in consumer spending and inflation expectations would suggest otherwise.

So there you have it: The signals from the bond market are mixed and conflicting, and something’s got to give. Either the economy rebounds, likely causing credit-sensitive bonds and TIPS to outperform … or the economy continues to slow, and foreign and long-duration bonds outperform.

Over the past few months, it has hardly mattered how you were positioned in the fixed income market. Returns have been good across the board. However, positioning is likely to be important in driving returns going forward. The most vulnerable investors are those who have been chasing yield with a combination of low-credit-quality and/or long-duration bonds. We think those who have stuck with core bonds for the majority of their portfolios and limited duration to the intermediate term may experience some volatility, but should be better positioned to ride out a realignment of the trends.

1 The definition of “core” bonds can vary, but they are generally considered to be a group of bonds that can provide investors with broad exposure to the investment-grade area of the bond, including U.S. Treasury bonds, mortgage-backed securities and investment grade corporate bonds.
2 Source: Federal Reserve Bank of Atlanta, GDPNow, as of 04/19/2016.

Kathy A. Jones is senior vice president, chief fixed-income strategist, at the Schwab Center for Financial Research.

©Charles Schwab & Co.