“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy.”
The phrase “just below” in Federal Reserve chairman Jerome Powell’s recent remarks caught the market off guard. The statement comes as the U.S. economy shows signs of cooling. A slowing housing market, auto plant closures, falling oil prices (which are often a proxy for economic activity), and a cycle of lower earnings forecasts for 2019 have dominated the recent headlines.
While most bond strategists had been predicting the Fed will boost rates in December and up to four more times in 2019, the door is now open for much less aggressive action. That new sentiment has helped push the yield on 10-Year Treasuries below 3.0 percent, its lowest point since mid-September.
Fewer rate hikes might lead to rising bond prices and falling bond yields (bond prices and yields move in opposite directions), and the bond market's response to Powell has been quite clear.
Nonetheless, strategists at both Goldman Sachs and JP Morgan are standing by forecasts that the Fed will boost rates four times next year. And Steve Laipply, head of fixed-income strategy at iShares, believes investors shouldn’t be too quick to conclude the Fed is nearly done with rate hikes.
“Powell was simply asserting that the FOMC (Federal Open Markets Committee) isn’t on auto pilot, and instead will rely on economic data to guide their policies,” he says.
Since we don’t have a clear read on how many rate hikes are in store, what’s the best framework for fixed-income investors to consider in 2019? Andy Chorlton, head of U.S. multi-sector fixed income at Schroders, says a defensive posture may be prudent.
Many firms have sharply boosted their borrowings as part of M&A strategies, he says, and any further slowing in the economy could create trouble for corporate debt default rates.
“Highly levered firms represent clear risk during this part of the cycle.”
Laipply agrees, noting the recent rapid drop in energy prices could produce fresh strains in the high-yield market as we saw when oil prices plunged a few years ago. Growing concerns about junk bond defaults in 2019 have led the average yield on the BofA Merrill Lynch U.S. High Yield Constrained index to rise to a recent 7.2 percent.