2019 – The Year of Volatility and a Year to Stay Active – Interest Rates

Interest Rates - A Topic That Needs No Introduction

The direction of interest rates and the shape of the yield curve are key determinants of returns in the fixed income markets. This will be no different in 2019. The interest rate volatility experienced in 2018 will likely be repeated in 2019 as markets determine the right balance of risk and insurance/protection. While historical correlations between rates and equities showed signs of breaking down, we see a risk of an even higher correlation in 2019. The implications of stocks and bonds moving in tandem have significant implications around the preservation of capital. Many investors will ask the question, “Where is the best place to hide?” We think they should be asking the question “Where is the best place to be?”

With a flat interest rate curve, there are consequences for both interest rates and fixed income risk assets.

Investors will need to consider the drawdown risk associated with limited yield pick up as they move out the curve. Similar to 2018, we believe that the front end offers some of the most compelling risk-adjusted returns. The long end should be monitored closely for opportunities.

We believe the marketplace will once again default back to focusing on real rates and inflation expectations. The inflation outlook will prove to be challenging for many investors as the inflation rebasing effects come into play in the back half of this year. We will also be fighting headlines of rising wages, input costs, and other direct components of inflation. The complacency around inflation that has been built over the years surrounding the ‘disruption’ theme and deflationary ‘demographics’ will be challenged this year.

Ultimately, the economic outlook and the health of the consumer will garner the greatest focus and be the key driver of risk assets. Growth may prove to be on more solid footing than many expect. At Smith Capital Investors, we expect a sequence of the events – stable economy, stirring of inflation and the Fed forcing the market to come up to their now moderate 3% projection - to occur in September 2019, causing interest rates to move higher into the end of the year and allowing the Fed to get another rate hike pushed through the market. Complacency will not be an investor’s friend in this environment; it’s time to know your fixed income manager and know how they invest.