As Sands Shift, Bond Investors Struggle to Keep Their Footing

Is the end of quantitative easing (QE) a big deal? Might tax reform provide an added boost to the US economy? Should investors brace for more volatility in 2018? Yes, yes and yes.

In other words, we think 2018 may go down in history as an important turning point for markets. That means bond investors should be extra vigilant when it comes to managing exposure to the market’s two primary risks: interest rates and credit.

Why? To start, we think financial conditions are likely to get tighter this year. The Federal Reserve began draining liquidity from the system through rate hikes and balance-sheet reduction in 2017, but conditions remained loose. Bond yields stayed low, the yield curve got flatter and “risk” assets continued to rise.

That may change this year. We think the Fed will hike interest rates four times in 2018 and continue to shrink its massive balance sheet. And with euro-area growth improving, the European Central Bank is likely to finish tapering its monthly bond purchases in the second half of the year and begin raising official rates in early 2019.

This matters, because it was extremely stimulative monetary policy that has allowed global investors to enjoy nearly a decade of rising asset prices and low volatility. More recently, we’ve also seen the world economy, led by the US, finally emerge from the long shadows of the global financial crisis and the Great Recession.