Fixed Income Outlook  |  Q1 2020

Bonds likely to be range bound in 2020

Fixed Income Team

Bonds likely to be range bound in 2020

  • U.S. Treasury yield curve may steepen as the Federal Reserve keeps rates on hold.
  • We have a favorable outlook on corporate credit, municipal bonds, and mortgage-backed securities.
  • We believe recession risks are waning amid accommodative monetary policies.

Global growth will likely stabilize and remain soft as we head into 2020. A recession remains relatively unlikely as central banks around the world lowered interest rates and trade tensions eased. The U.S. economy, now in its 11th year of expansion, will continue to grow at a more moderate pace compared with 2019. The Federal Reserve held interest rates steady in mid-December and signaled no appetite to raise them soon. The central bank had cut rates three times in 2019.

U.S. Treasury yields are also on an uptrend, marking a significant reversal for the bond market. The yield curve was signaling recession over the summer, but the Fed's easing and positive trade developments helped turn the tide. Short duration yields are no longer higher than the rates on the long end, like the benchmark 10-year Treasury note. Within this environment, we think intermediate- and long-term bond yields are likely to drift higher. Elsewhere, the European Central Bank (ECB) left its key interest rate at a record low and restarted bond purchases. India, Brazil, China, and other emerging-market central banks have also lowered rates.

Stabilizing global growth and accommodative monetary policies will provide support for the markets, including fixed-income securities that are highly sensitive to positive "risk-on" sentiment. The modest U.S. growth environment should be sufficient to support corporate fundamentals as we head into 2020. We have a favorable outlook on corporate bonds, municipal bonds, and mortgage-backed securities. The dollar — a currency safe-haven — will likely trade within a limited range this year on the back of fluctuations in risk appetite. The Bloomberg Barclays U.S. Aggregate Bond Index advanced 0.18% during the fourth quarter.

Bright spots in the U.S. economy

Growth should settle in at a lower gear next year, and we expect the economy to grow at a pace of 1.75% to 2.00%. The Fed expects growth of 2.0% in 2020, down from the 2.2% rate it forecast for 2019. The job market and consumer spending continue to be resilient. The housing market has also picked up as the Fed shifted to a more accommodative monetary policy stance early in 2019. Activity in the services sector rose slightly in December, but manufacturing activity shrank for a fifth month. The ISM's manufacturing gauge fell to 47.2% in December, its lowest level in more than 10 years, signaling a weak start to the year. Readings below 50 indicate contraction in the economy.

There will be a lot at stake in the 2020 U.S. presidential elections as Republicans and Democrats wrestle to take control of the White House, the Senate, and the House. The outcome is likely to influence everything from Wall Street and the economy to businesses and trade policies. So, the election will be one of the key events we will be following closely this year as it may cause headwinds for financial markets.

The Fed's wait-and-see outlook

Fed chair Jerome Powell and his colleagues have indicated comfort with leaving monetary policy on hold through 2020 while keeping an eye on trade and global growth risks. In December, the Fed penciled in no rate changes this year and saw only one move, an increase, in 2021, followed by a second in 2022. Powell said the "economic outlook remains a favorable one." The Fed cut its benchmark fund rate three times between July and October to a range of 1.50% to 1.75%. The central bank also began buying short-term Treasury bills in October and may continue those purchases into the second quarter of 2020. As a result, we don't expect short-term interest rates to move significantly over the near term. Consequently, we believe the yield curve is likely to continue its recent steepening trend.

Strong market dynamics and the phase-one trade deal between the United States and China sparked a rally in Treasury bond yields in the fourth quarter. Treasury yields had started 2019 in a downward spiral as investors fled risk assets and flocked to safety amid an escalated U.S.–China trade war and weakening economic signals. By the end of last year, the yield on the 10-year note rose to around 1.92% from around 2.7% at the start of 2019. The 2-year note yield, which rose above the 10-year security over the summer, tumbled to around 1.58% at year-end. We expect to see a steepening of the yield curve this year.

ECB's policy dilemma

The eurozone's economy continues to be plagued by slow growth. And with interest rates already at record lows and its balance sheet inflated, the ECB has limited policy tools. The bank launched a massive stimulus package in November including new lending conditions to commercial banks and a second round of QE. The current deposit rate is -0.5%, the lowest on record. The eurozone is forecast to grow 1.1% in 2020 and 1.4% in 2021 from 1.2% last year, according to the ECB. ECB president Christine Lagarde, who succeeded Mario Draghi, has called for a more aggressive approach to public investment spending to stimulate demand and growth prospects, and to rebalance the policy mix.

Politics are also back in focus. British Prime Minister Boris Johnson won a decisive majority in the December general election, paving the way for parliament to trigger a long-delayed split with the European Union. Johnson has promised to complete the U.K.'s protracted exit from the EU by the end of January 2020. Germany, Europe's biggest economy, continues to grapple with rising unemployment and a weakening manufacturing sector. And Italy, the eurozone's third-largest economy, has been broadly stagnant over the past year as the coalition government contends with reining in rising debt levels.

China aims to set growth pace

China's economy, the world's second largest, is slowly decelerating with some signs of stabilization. The government adopted various stimulus measures to cushion the economy over the past year. In January 2020, the central bank said it would add an estimated $115 billion into the financial system to reduce bank lending rates to businesses. The move comes after a similar action in September. The economy has weakened with the trade war and a slowing global economy. The official manufacturing Purchasing Managers' Index stayed in contraction territory for most of 2019. We forecast growth next year will be in the 5.5%–6.0% range.

But there was some good news. Easing U.S.–China trade tensions lifted demand for Chinese goods and boosted factory production in December 2019. China and the United States in mid-December agreed to a so-called phase-one trade agreement in their long-running tariff war. The initial deal helped diffuse market uncertainties and forestalled new tariffs. Presidents Trump and Xi Jinping announced they would sign the first phase of the agreement in January, though exact details of the deal have not been released.

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