Fixed Income Outlook

Fed Rate Hikes, Tax Cuts and Foreign Central Bank Policy Hold the Keys to Bonds This Year 

Departure of old-time hawks from Fed Board portends focus on pushing growth while keeping rates low but not inflationary. 

Policy decisions in Washington continue to have a dominant influence on the bond market. On December 20, Congress approved the biggest overhaul of the U.S. tax code in more than 30 years and President Trump signed it into law a week later. The Tax Cuts and Jobs Act will cut an estimated $1.5 trillion in taxes and further stimulate growth in the economy. The legislation cuts tax rates for individuals across the board and should “simplify” the tax code by modifying some deductions and personal exemptions. The corporate tax rate has been slashed to 21% from 35%.

At a time when the U.S. economy is already growing fairly well, with strong corporate earnings, robust retail sales during the holidays and unemployment near historic lows, the nagging question is why these factors are not pushing longer-term interest rates higher.

Now that the tax plan has passed and is being implemented, the budget funding resolution takes top priority in Washington. Instead of passing a budget, Congress has passed a series of continuing resolutions in the fourth quarter of 2017 that continued the funding of the government for several weeks at a time. In late January Congress again passed a short funding resolution until early February. The Senate has tied the immigration debate to the budget resolutions, complicating the process. Neither party wants to be held accountable in the court of public opinion for shutting the government down and facing the political backlash.

The biggest impact on the bond market, however, is likely to be the Federal Reserve. The Fed is expected to continue raising short-term interest rates in 2018, and is also shrinking its enormous balance sheet resulting from the quantitative easing programs it undertook during the financial crisis. Both of these actions should put upward pressure on interest rates.

The bond market will also be focused on the composition changes to the Federal Reserve’s Board of Governors and how it may affect the path for interest rates. Fed Chairman Janet Yellen’s term ended on February 5th and she has been succeeded by Jerome Powell. Moreover, four out of seven seats on the Board of Governors remain vacant, including the vice chairman. President Trump is expected to appoint individuals who favor high growth and low interest rates. The FOMC is expected to do everything it can to both push growth higher and to keep interest rates as low as they can, at least to a point, in order to keep inflation under control.

Overall, the tax cuts could potentially cause two very different scenarios to unfold in the fixed income market. First, given that they could push economic growth and the threat of inflation higher than currently expected by the market, the Fed may be compelled to restrict monetary policy more than anticipated in order to thwart any would-be inflation outbreak. That is, the Fed might hike rates more than three times in 2018 or it might hike rates more rapidly than expected if tax cuts prove to be more stimulative than expected. This, however, may lower returns for bond investors.

A Flattening Yield Curve

The flattening of the U.S. Treasury yield curve will be a key factor in near-term Fed actions regarding interest rates. The spread between the yields on the 2-year Treasury note and the 10-year Treasury note narrowed by 70 basis points from 125 points at the start of 2017 to just 55 points at the end of 2017. The yield curve flattened as 2-year note yields rose in response to the Federal Reserve raising short-term interest rates while 10-year note yields were unchanged.

There are two things preventing 10-year Treasury yields from moving higher: lack of inflation growth in the domestic economy and foreign buying of the U.S. 10-year. U.S. rates are higher than those in Europe and Japan and the liquidity provided by foreign central banks has been used to buy the U.S. 10-year note. Interest rates in Europe are still mostly under 1.00%, and Japan’s 10-year note is now trading at 5 basis points. 

Speak with an adviser

10 Year Treasury Note First Quarter 2017
10 Year Treasury Note First Quarter 2017

If the European Central Bank (ECB) and the Bank of Japan slow down their quantitative easing programs and eventually raise their short-term rates, it may draw foreign buyers out of U.S. Treasuries. That’s when we could see U.S. interest rates push higher. The ECB said it will start reducing its buying in the market in 2018.

The consensus is that the Fed will tighten rates two to four times this year. With the lower band of the Fed funds rate now at 1.25%, it’s likely to be trading near 2.0% by the end of 2018. With a 2.00% Fed Funds rate, the 2-year Treasury would be expected to yield between 2.25% and 2.50%. The 10-year Treasury yield would be expected to be between 2.75% and 3.00%.

Tight Spreads in Investment-Grade Corporate Bonds

After running at a record pace for a single year in 2016, which looked to be exceeded through November of 2017, new supply of investment grade corporate bonds was significantly smaller than expected in December. Total issuance for 2017 ended the year at $1.63 trillion, slightly below $1.65 trillion in 2016.  New supply is expected to pick up by mid-February, especially in the financial sector. 

Key Fixed Income Asset Class Returns First Quarter 2017

Starting in October, credit spreads have been at decade-long tight levels that haven’t been seen since 2007. The spread for investment-grade bonds on the Barclays index is now at 93 basis points. The next tightest level, 76 basis points, was last seen in 2005, and the next tightest level after that was 51 basis points back in 1997. That indicates plenty of room for spreads to tighten further, though they seem to be currently stuck in a range. New debt issuance in the months ahead will show whether spreads will hold at current levels or tighten further. Demand for investment-grade bonds is strong amid broad-based corporate stability and increasing profits, so there is no reason for spreads to widen. Spreads could tighten further if supply turns out to be weaker than expected.

High-yield bonds have followed suit, hitting decade-tight levels in credit spreads in October, though they have widened slightly since then. Commodity prices, which stabilized in 2017, lent strength to the junk bond market. Returns came from the bottom, with triple-C rated bonds outperforming the single-B and double-B sectors. Junk bond sales were 20% higher in 2017 than in 2016, with a total of $275 billion priced. If market conditions continue as they have, new supply is expected to hit about $350 billion this year. Generally speaking, high-yield spreads should follow the equity market. If there is a downturn in equity prices, expect spreads to widen.

Municipal Bond Supply

Lower corporate and individual tax rates usually translate to higher rates for municipal bonds. However, the tax plan makes future pre-refunded bonds no longer eligible for a tax exemption. This is likely to reduce new issuance by 15% to 25% in 2018, probably enough reduction in supply to negate higher yields caused by lower tax rates.

In anticipation of the tax bill’s passage and of municipalities losing their ability to refund bonds prior to maturity, there was a surge in supply of muni bonds in November and December, with new supply increasing 29.3% and 207%, respectively, over prior-year levels. Similarly, new issuance of munis in December hit a new monthly record high of $55.4 billion, which should limit the supply of new issues in the first quarter of 2018. If issuance remains low as expected, the value of triple-A rated muni yields relative to 10-year Treasuries should compress by five to ten basis points, from the current 82-85% to 72-75% of the 10-yr Treasury yield. Municipal yields should rise at a slower pace than U.S. Treasury yields due to the limited supply of new municipal issues.

As a result of the elimination of advanced refunding in the new tax law, there is likely to be a change from the traditional structure of tax-exempt bonds. Until now, most bonds longer than 10 years have had a 10-year call feature. Now that advanced refunding has been discontinued, issuers could command a little more flexibility in their financing structure. This could result in shorter call features allowing municipalities to retire debt in significantly less time they had been able to previously.

Higher retail sales, higher home prices, and general economic strength should generate more revenues for municipalities, which could also mean reduced issuance of new bonds and lower muni yields for investors. The muni market is believed to be in the mid-stage of its credit cycle, with little evidence of distressed issues. Although muni bonds continue to be issued, issuance may decline if the economy keeps charging ahead and municipalities look to other sources of funding for local projects.

Contact Form

Global Wealth Contact Us

Please complete the form below to contact BBVA Compass Global Wealth via email, or view our list of locations.


Important: Please do not enter your account number, social security number, or any other confidential information in this area.


Details you need to make a smart decision

BBVA Compass is the trade name for Compass Bank, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg;;; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).