Also keep in mind that flexible bond strategies have the potential to outperform in rising and flat interest rate environments, and can help provide meaningful diversification, which may reduce overall volatility in a portfolio. Their greater flexibility allows the implementation of many of our key outlooks this year: yields that move in very different ways depending on the maturity, as front end rates lead higher rates from Fed policy changes, but back end rates look vulnerable from overpricing fears of deflation. Decoupling bonds from their currency risk in Emerging Markets as well represents another favored strategy that flexible bond strategies can employ to help investors navigate a more volatile investment environment in 2015.
When the Fed does raise rates—and we expect that in June—then the largest impact will be felt in the shortest maturity yields. The historical record shows that even though this should not be any “news” to anyone, the bond market inevitably tends to overreact. The result is an increase in short-term interest rates beyond what is currently reflected in market expectations and the consensus view, leaving our 2-year forecast a bit higher at 1.75%.
And higher short-term interest rates is one reason we disagree with market consensus concluding that a world of low interest rates means the 10-year can never rise. We believe that when the Fed starts raising rates in the front end it will want to see long-end rates rise as well. This is to both avoid over stimulating the housing market (a mistake they now admit occurred during the last cycle) and to avoid the negative signal of inverting the yield curve. And though the market may have forgotten it, the Fed has $4.5 trillion reasons to make sure that outcome occurs. That leaves us expecting modest increases in the 10 year rate to 2.5% for year-end 2015.
Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog. You can find more of his posts here.