There were three big trends in the bond market in 2017: Fed hiking, curve flattening, and credit spreads tightening. All three were persistent all year, and all three have major implications outside of just the bond market.
Getting 2018 right, and not just in bonds, is going to mostly be about figuring out whether these trends continue or reverse. Here's how I'm approaching each:
The Fed will definitely keep hiking, but how far?
This is a more complex problem than it might seem. We can easily look at the Fed's most recent "dot plot" and compare it to what the market has priced in. Fed funds futures are priced at about 1.90%, or roughly two hikes. The median of the Fed's dots is at 2.125%, or three hikes.
But for thinking about the direction of interest rates, it isn't just about how many hikes we get in 2018. It is the combination of how many hikes we get plus how many are priced in going forward. In other words, if the Fed hikes three times in 2018 but is seen stopping there, there is a good chance that the 10-year Treasury is actually lower than the 2.45% yield where it is trading now. Whereas if the Fed only hikes two times in 2018 but is seen hiking three-four times more in 2019, the 10-year yield will definitely trade higher than 2.45%. Note that the market currently only has about half a hike priced in for 2019 and beyond (after the two it is pricing for 2018).
My view is pretty simple: The Fed will keep hiking at a pace of roughly one time per quarter, until economic conditions suggest otherwise. Core PCE, the Fed's favored inflation measure, was just 1.5% over the last year, and yet the Fed still hiked in December. On balance, the FOMC in 2018 will be more hawkish than the same body in 2017, which means, if anything, the bar to stop hiking is higher, not lower. I'd guess the actual inflation prints don't really matter, as long as the employment picture remains strong.
I'm not going to offer a specific prediction about how many hikes the Fed will do, but the risks are heavily weighted toward more than the market expects, especially for 2019. If we get to mid-year and the economy is still humming, the market may price in two-three hikes more for this cycle than it is currently.
If that happens, the curve will likely invert
If the Fed keeps hiking, the curve will keep flattening. I've written about this several times in recent months, (for example here), but the short version is that both history and basic economic theory back this up. To be sure, if the market starts thinking the Fed gets to 2.5% or 2.75% in 2019, short and intermediate-term bonds will have to rise in yield. Right now, the two-year is only at 1.91% and the five-year is at 2.23%. Whether that is enough to push the 10-year a lot higher than 2.45%, I'm not sure.
Ultimately, though, the curve will invert. It is only a matter of how quickly it gets there. I believe by the end of 2018 the two-year is higher than the 30-year, or is darn close.
Putting these two together, I like outright shorts on Treasury bonds with three-seven years to maturity. I also like a pair trade of shorting the five-year vs. the 30-year at approximately a one-to-three ratio.
Credit spreads will keep grinding, in the first half at least
Credit spreads on corporate bonds (which is just the yield gap between a corporate bond and a correspondent Treasury bond) are very tight. This is the tightest they have been since pre-Great Recession, which has gotten a lot of press. What is rarely stated, though, is that credit spreads have routinely stayed this tight (or even tighter) during extended periods of strong economic growth. Here is a fairly easy way to think about it: The only reason you get paid extra yield to own a corporate bond is because it might default. If economic growth is strong, few companies will default. So, when growth is strong, credit spreads can stay tight.
It is also true that credit spreads tend to only widen once default risk becomes a palatable risk. We could see this in 2007, when credit spreads started to rise about six months before the recession came. We can also see this in the head-fakes in 2011 (eurozone crisis) and 2015 (oil price shock). Spreads don't move wider just because; they move wider because the market sees real risks.
It is hard to see such problems cropping up for at least the next six months. Barring some huge shock, like a nuclear exchange with North Korea, the economy just can't turn that fast. We have too much positive momentum now to imagine that we suddenly turn south by mid-year. Ergo, I believe credit spreads will keep grinding tighter. High-yield bonds should keep performing well, and investment-grade bonds should at least outperform Treasuries. Even beyond six months, I'd be pretty surprised if we are talking about a slowdown until at least a year from now.
However, not all high-yield risks are created equal. When credit markets are strong, it isn't just corporate bonds tightening compared to Treasuries, but different types of corporate bonds tightening relative to each other. Bond guys call this a "compression" trade. One of the first things that will happen when the tide turns is a decompression. Weak-handed trades in poor quality and/or highly cyclical bonds will look to sell, and those sorts of bonds will behave especially badly.
What I'm doing in credit is looking for bonds that are held by strong hands and are unlikely to be seen as especially risky in the early stages of a recession. That way, if I'm wrong about when the cycle turns, I'm not caught in the teeth of it. Granted, the riskier bonds probably have a bit more yield right now, so it can be tempting to reach to a get a little more income. But I think in the end, earning a solid yield with low risk is better than earning slightly more, but with a lot more risk.
That doesn't mean you can't own junk bonds; we are just being very selective. I'm focused more on the cyclicality of the business than the credit rating, but we no longer hold anything rated CCC. If you are going to use ETFs, I don't mind owning iShares iBoxx $ High Yield Corp Bd ETF (HYG) or SPDR Blmbg Barclays High Yield Bd ETF (JNK) , but it isn't the ideal way to play this part of the cycle.
This commentary originally appeared on Real Money Pro at 11:30 a.m. ET. Click here to learn about this dynamic market information service for active traders.