2020 Market Outlook: Fixed Income

Key takeaways

  • Ten-year Treasury bond yields should move higher in 2020 as recession fears ease. Barring a setback on trade, yields could move back up to the 2.25% to 2.5% area.

  • The Federal Reserve is likely on hold for the foreseeable future. The three short-term rate cuts in 2019 successfully “un-inverted” the yield curve.

  • Investors should consider adding bonds with longer maturities to their fixed income portfolios if 10-year yields do move above 2.25%.

  • The value of the U.S. dollar should remain firm on continued outperformance by the U.S. economy relative to other major countries. However, further gains are likely to be small.

Easing recession fears should boost bond yields

Ten-year Treasury yields should move higher in 2020 as recession fears ease. The lagged impact of the Federal Reserve’s interest rate cuts, signs of stabilization in the global economy and a modest uptick in inflation expectations should provide a boost to intermediate- and long-term bond yields. The risk to our outlook is the ongoing threat of trade tariffs weighing on business investment. Barring further setbacks on trade, 10-year Treasury yields could move up to the 2.25% to 2.5% area, while the chances of a drop back below the 2019 low of 1.52% are diminishing as global recession fears abate.

With the yield curve now “un-inverted” and signs of economic stabilization, the Fed likely will be on hold for the foreseeable future.

 

Inflation expectations may rise

The key to higher yields on intermediate- to long-term bonds will be rising inflation expectations. With the economy showing resilience and core inflation edging up, inflation expectations should move higher, potentially adding 50 to 75 basis points¹ to 10-year Treasury yields. Breakeven inflation rates are low, so TIPS are attractive relative to nominal Treasuries for those looking for inflation protection.

Despite signs of economic stabilization, we see risks in the more aggressive segments of the bond markets, like high-yield bonds, bank loans and emerging market bonds. We suggest reducing exposure to high-yield bonds, while moving up in quality in the investment grade market. Municipal bond valuations have improved from early 2019 levels and still appear attractive for investors in higher tax brackets.

 

Takeaways

  • Treasury Inflation-Protected Securities (TIPS) appear attractive. Inflation expectations are low, making the inflation protection that TIPS provide relatively cheap.
  • Underweight high-yield bonds. The yield advantage they offer relative to Treasuries is low, while corporate profit growth poses a risk in 2020. Investors also should move up in quality in investment-grade corporate bonds, focusing on bonds with “A” ratings or above.
  • Consider higher-rated municipal bonds with maturities in the five- to eight-year range. Net supply of these bonds is likely to remain low, keeping prices from falling much.
  • Stay local. International bonds provide diversification, but not much yield. It would take a significant drop in the dollar to make up for the wide yield gaps.

About the author

Kathy Jones

Senior Vice President, Chief Fixed Income Strategist, Schwab Center for Financial Research