Bracing For Turbulence In Fixed Income

It’s been three years since the Federal Reserve commenced its rate hikes, and fixed-income experts are hoping for a pause in 2019. Should the Fed continue to ratchet up the federal funds rate, which it has raised nine times since December 2015, bond investors fear it could push the U.S. into another recession sooner rather than later and send the markets tumbling.

They don’t anticipate this gloom and doom, but they are exercising caution amid mixed messages from the Fed, market volatility, investor anxiety and big global question marks.

In December, the Fed initiated its fourth rate hike of the year and projected two more hikes in 2019, although it sees economic growth moderating. The language of Federal Reserve Chairman Jerome Powell has been keenly observed. In October, he said that interest rates were “a long way” from their neutral level—the rate at which GDP is growing along its trend rate and inflation is under control. Those words sent equities plunging. In November, those seemingly innocuous words were changed again to the even more innocuous statement that rates were “just below” their neutral level. After that, markets took off again.

U.S. economic news has been good, says Peter Palfrey, co-manager of the Natixis Loomis Sayles Core Plus Bond Fund, “but markets are fearful and we’re starting to speculate that things are going to get uglier before they get better.”

Global growth has slowed, partly from the spat the U.S. has had with China and its tensions with many of its other trading partners as well, Palfrey says. The tariffs President Donald Trump imposed on steel, aluminum and washing machines apply to all countries the U.S. partners with and “was kind of a one-two punch against trade relations,” Palfrey says. If the U.S. and China remain at odds, it will disrupt trade globally and have “a dramatic ripple effect across all markets,” he adds.

Palfrey thinks U.S. economic growth can remain robust this year, though its big drivers have waned. These drivers included the “sugar high” from former very expansionary fiscal policy, the one-off tax cuts at the corporate and individual levels and the continued recovery from the 2015-2016 commodity bust, he says.

Loomis Sayles had already expected the Fed to initiate two rate hikes in 2019, most likely in June and December. If there were going to be more than two hikes, there would first have to be stabilization in the oil and equity markets and some progress in U.S.-China trade relations, Palfrey says.

“We do feel that the market has perhaps priced in too much bad news,” he says, so he’s been shaving duration in the Core Bond Fund, whose chief allocations are to agency mortgage-backed securities (30%) and investment-grade credit (26%).

When taking pricing into account, he finds foreign credit (particularly in emerging markets) more interesting than domestic credit. “We think you can get a little more yield without taking on too much incremental credit risk,” he says.