By Gregory S. Kaplan, CFA and David Krouth, CFA
- A flat, but not inverted, yield curve is likely to persist this year
- A near-term recession is unlikely
- Actively managed strategies should outperform passive/indexed products
Interest rate volatility remains near all-time lows as improving GDP growth, subdued inflation expectations and three rate hikes by the Federal Reserve in 2017 generated little change in longer-term interest rates, but did produce a significant uptick in shorter term rates. These trends resulted in a material flattening of the yield curve, with the differential between two-year and 10-year Treasury yields finishing 2017 at just 51 basis points, down from 125 basis points at the start of the year (see chart).
Recessions have historically been preceded by a flattening and eventual inversion of the yield curve, where longer-term rates yield less than shorter-term rates. With the current economic expansion getting long in the tooth, some market participants are worrying about this growth ending. Although an inverted yield curve is a leading indicator of a coming recession, it does not cause a recession and is not great at timing a downturn. As shown in the chart, the yield curve inverted 1.5 years prior to the 1990 recession, one year before the 2001 recession and nearly two years prior to the 2007 recession.
For 2018, City National Rochdale expects an additional two to three rate hikes and a yield curve that will flatten, but not invert.
Investment Grade Taxable and Municipal bonds should benefit from strong inflows, open capital markets, and credit spreads near 10-year lows. Corporate tax cuts, synchronized global GDP growth and strong corporate fundamentals will also help the taxable market. The flat yield curve, tighter monetary policy and a potential uptick in M&A may serve as headwinds. Municipals should benefit from a reduction in supply.
We expect credit spreads to remain somewhat range-bound and Investment Grade Taxables and Municipals to provide modest single-digit total returns. 2018 looks to be a year where security selection, tactical yield curve positioning and the ability to tap into unique opportunities will provide superior returns relative to passive allocations.
Read the next article in this series: High Yield Municipal Bonds Moving the Needle
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