Fixed Income’s Rough Start to 2018, but Bright Spots May Lie Ahead

The first quarter of 2018 was not the most pleasant for fixed income investors, but John Lynch noted that “the bright side is that bonds may rebound from a total return perspective over the remainder of 2018.” Rising yields, and thus falling bond prices, were the main cause of pain for fixed income investors during the quarter, leading to negative returns for most segments of fixed income (see the chart below). At shorter maturities, a deluge of Treasury supply pressed rates higher, as did increasing expectations for Federal Reserve rate hikes. Rising growth and inflation expectations pushed longer-maturity yields higher throughout the quarter, with the 10-year yield reaching 2.95% on February 21, 2018, its highest level since January 2014. Long-term rates have subsided from recent highs amid equity market volatility. The 10-year yield gave back 21 basis points (0.21%) from its February high, yielding 2.74% as of quarter end.

As of early February, fixed income markets were priced at what we believed to be unsustainable levels, reflecting investors’ expectations for “economic perfection” (see “Will Yields Keep Rising?”). Real (inflation-adjusted) rates had risen, indicating higher growth expectations, and breakeven inflation rates had moved higher by 40 basis points (0.40%) since early September 2017. Several factors indicated that the rise may have gone too far too fast, leading to a potential relief rally, which we have seen over the last several weeks.

Given that the 10-year started 2018 at 2.4% and currently stands just over 2.8%—we are two thirds of the way to the center of our year-end yield estimate, only a quarter into the year. Even looking at the high end of our range target (3.25%), we are about halfway there, potentially making the rest of the year more pleasant than the start.



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