Global Fixed Income

Weekly discussion of fixed income market action and what it may mean for investors.

September 20, 2016

Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

A Slow Pace of Hikes and Low Rates in 2017

  • We expect a slow pace of Federal Reserve (Fed) rate increases and low interest rates in 2017.
  • Our year-end 2017 targets for the 10- and 30-year Treasury yield are 1.50-2.00 and 2.00-2.50 percent, respectively, while our fed funds rate forecast for year-end 2017 is 0.75-1.00 percent.

What it may mean for investors

  • While we expect a lower-for-longer rate environment, we also anticipate an increase in volatility as the Fed manages through late-cycle hikes.
  • We recommend that investors maintain a globally-diversified portfolio of fixed income, equity and other holdings. We favor regular rebalancing to remain aligned with long-term asset allocation and investment goals.

We expect two Fed rate increases before the end of 2017 as the Federal Open Market Committee continues its cautious approach to normalizing interest rates.

The Fed typically increases rates in response to an economy that is growing at a faster-than-ideal pace or to inflation levels above those which are consistent with price stability. A rapidly-growing economy can induce undesirable price increases or inflation. We have seen improvement in the trends of current inflation measures such as the Consumer Price Index (CPI), which we target to end 2017 at 2.1 percent. Yet, the Personal Consumption Expenditures (PCE) Index, the Fed’s preferred inflation measure, is likely to remain below the Fed’s target of 2.0 percent throughout 2017—limiting the risk that the pace of rate increases could accelerate.

Table 1. Year-end 2017 Fixed-Income TargetsTable 1. Year-end 2017 Fixed-Income TargetsSource: Wells Fargo Investment Institute, 9/16/16.

The precise timing of future rate hikes can be difficult to predict as the Fed adjusts to fluctuating global, market and economic conditions. It is imperative that investors focus on the general path of rate increases. It should be clear that the Fed will move forward at a very gradual pace. We anticipate that the Fed will be unable to move the federal funds rate to align with its longer term target of 3.0 percent before the next economic downturn.

While the Fed has the power to explicitly increase short-term rates, investors should not assume that long-term rates also will rise. As short-term rates slowly increase, we look for longer-term rates at year-end 2017 to remain near current levels, resulting in further curve flattening.

There are several factors that should continue to support bond prices, even if current inflation measures continue to normalize in the coming year. These include the following:

  • Inflation expectations remain near historically low levels.
  • Rates close to, or below, zero in many countries should continue to provide support to domestic fixed-income investments as global investors seek higher-yielding assets.
  • Strong demand for income securities as the population ages: Insurers and pension plans continue to purchase longer-maturity bonds to help manage the demographic shift.
  • Central-bank bond buying: Inflated central-bank balance sheets reduce the available supply of longer-dated bonds. We do not expect that central banks will reverse course and sell securities in 2017.

Should rates move higher, buyers are likely to emerge to purchase at yield levels that have been unattainable recently. We expect that this demand will act as a strong offsetting factor to keep rate movements contained.

While we expect a lower-for-longer rate environment, we also expect an increase in bond-market volatility as the Fed manages through late-cycle hikes. We foresee rates potentially moving both above and below our year-end target range throughout the forecast period.

What could cause us to change our expectations?

An unexpected pickup in inflation or inflation expectations could push rates above our year-end targets. We see such a scenario as unlikely, given that longer-term inflation indicators have remained low and not responded the rise in energy prices or expectations of economic-growth improvement.

Surprise fiscal coordination could unexpectedly increase the pace of economic growth. We assume that governments are unlikely to initiate significant new fiscal spending initiatives in the coming year. Central bankers have been asking for better-coordinated action from legislators to support monetary goals. We view such coordination as unlikely given the partisan atmosphere.

Rates could move below our targets if the economic cycle is closer to the end than we expect. While we look for the current economic expansion to continue throughout 2017, the economy may be more susceptible to a slowdown or recession than we expect. A shock or turn in the economic cycle could push actual rates below our targets.

We view the upside and downside risks to our targets as balanced.

Risk Factors

All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.

Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.

Forecasts are not guaranteed and are subject to change.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII) WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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