Short-term bonds are looking attractive again after years of near-zero yields. The Federal Reserve’s rate increase this week only adds to the appeal. Markets are now pricing in two more hikes this year, in line with what the Fed signaled on Wednesday in its latest Summary of Economic Projections.

That market participants have finally come to terms with the Federal Reserve’s normalization plans is just one of the reasons short-term bonds are finally looking attractive again after years in the doldrums, as we explain in our new Fixed income strategy A mighty (tail)wind.

Why to consider a long on short-term bonds

We see short-term U.S. debt offering relatively compelling income, with limited downside risk, now that market participants have greater confidence in the Fed’s planned normalization path. In most of the post-crisis normalization period, the bond market significantly discounted Fed expectations for the pace of normalization.

The market has now caught up with the Fed’s view, with rising short-term interest rates reflecting this greater confidence. Market participants previously had good reason to be skeptical. 2017 was the only year the Fed delivered on its promised pace of normalization. But current economic tailwinds – tax cuts and plans for more government spending – suggest the central bank is poised to extend that recent track record.

We see it likely taking some time for any economic overheating to challenge the central bank’s gradual pace of normalization. We expect inflation to return to the Fed’s target, with the possibility of a temporary overshoot. But at least for 2018, we see little chance of the Fed increasing rates beyond a quarterly pace of 25-basis-point rate hikes.

Attractive risk vs. reward

Combined with what is already priced into front-end yields, this makes for attractive risk vs. reward. It means an investment perceived as “risk-free” now offers limited downside risk and positive after-inflation yields. A two-year Treasury yield now well above the core inflation rate restores a viable and perceived safe investment option that has been missing since the crisis.

Technical factors such as increasing U.S. Treasury bill issuance – the result of a surging budget deficit – are adding to the factors pulling short-term yields higher and making the short end look more attractive.

Lost revenues from tax cuts, twinned with greater government spending, mean more borrowing to fund deficits. We project the U.S. deficit to hit 5.7% of gross domestic product (GDP) by 2019, the highest since 1960, outside of the 2008 crisis aftermath. The deficit spike comes even as the jobless rate drops to multi-decade lows – an unprecedented disconnect. See the Diverging paths chart below.

Treasury bill and bond issuance are ramping up at a time when the Fed is reducing its reinvestment of maturing bond holdings. We estimate net bill issuance to the tune of roughly $500 billion in 2018, far beyond levels seen in recent years. The result: a need for greater private-sector financing of federal deficits.

The U.S. tax system overhaul also has created incentives for companies to repatriate overseas cash currently held in short-term instruments. Anticipation of these fund outflows is contributing to rising yields on shorter maturities.

Bottom line

We see rising opportunities at the front end of the curve, where yields finally above inflation levels offer investors a viable alternative to cash. Higher yields favor short over long maturities in government debt. We like floating rate and inflation-linked securities as buffers against rising rates and inflation, and also see opportunities in 15-year mortgages.

Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.

Listen to Jeff Rosenberg on the BlackRock podcast The Bid, where he discusses the role of fixed income in a volatile market.

Investing involves risks including possible loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of March 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. ©2018 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States or elsewhere. All other marks are the property of their respective owners. 454044

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