Where the bonds are: The outlook for fixed income

Are we in a bear market for bonds?

Bond luminary Bill Gross thinks so. Earlier this year, he suggested that the more than 35-year-old bull market that started in 1981, when the 10-year Treasury bond topped out at 15.6 percent, ended in 2016, when rates bottomed at 1.45 percent.

With interest rates surging 50 basis points from the beginning of this year to Feb. 21, it appears the bear is starting to show its teeth.

If this is the beginning of a bear market in bonds, however, it is unlikely to be a very long or painful one. Already, the 10-year yield has dropped back to 2.8 percent — largely as a result of President Donald Trump's desire to initiate trade wars.

"I don't consider this a bear market," said Matt Diczok, a fixed-income strategist for Merrill Lynch and U.S. Trust. "There's been an acceleration in economic growth, but inflation lags the economy and we see interest rates trending only slightly upward from here."

Diczok expects the 10-year Treasury bond to trade within the range of 2.78 percent to 3.38 percent this year, likely finishing above 3 percent by year-end. "I don't expect a big rate shock from here," he said.

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Nevertheless, rising rates always hurt fixed-income investments — floating-rate instruments being the exception. As interest rates rise, the prices of existing bonds fall in order to make the yield of their fixed coupons competitive in the market. After decades of generally declining rates and capital gains on bonds, investors may actually experience losses in 2018.

That doesn't mean you should liquidate your fixed-income portfolio. Bonds remain the most important asset to diversify the risk of owning stocks. While most market analysts expect rates to rise from here, nothing is guaranteed, and when the stock market has its next 10 percent dip, you'll be happy for your bond holdings.

"When you build a portfolio, you don't put 100 percent of your money into the highest-returning asset," Diczok said. "We guess about where the economy and markets will go, but things we never thought possible can happen."

The biggest factor driving interest rates higher is the economy. It has finally emerged from its post-financial crisis funk. While growth has been trending up fitfully for the last two years, many analysts think the U.S. economy could grow at a nominal rate of 5 percent this year. Unemployment could possibly fall below 4 percent, and while inflation is still below the Federal Reserve's target of 2 percent, wages and prices are climbing.

"There's a recognition that the macroeconomic backdrop is very different heading into this year," said Jeffrey Rosenberg, chief fixed-income strategist at BlackRock. "The post-financial crisis environment has been mostly about too little growth and too little inflation.

"Looking into 2018, the tilt has gone from risk to the downside to a realization that we may be on the other side of it now," he added.

The shock of the 0.5 percent jump in the consumer price index in January has abated. It rose by a more modest 0.2 percent in February and was up 2.2 percent over the last year (1.8 percent, excluding food and energy). While the personal consumption expenditures figure that the Fed uses to assess inflation is still lower, there is little doubt that inflation is rising.

"There is a different dynamic in the economy now," said Satyam Panday, U.S. economist for S&P Global. "The chances of wage inflation are higher this year than last; oil prices are up; the dollar is down. We see inflationary pressures at the margin."

Panday expects the CPI to stabilize around 2 percent by year-end. He sees upside risk to S&P's forecast of 2.8 percent real growth in the economy this year — in large part because of the fiscal stimulus of the recent budget ($300 billion in increased government spending over two years) and of the tax cuts that take effect this year. "It's a huge contribution from government spending," said Panday.

With the economy humming and the tax cuts adding further stimulus this year, the Federal Reserve has made it clear that its decade-long policy of extraordinary accommodation is over. Until recently, every attempt by the Fed to pull interest rates off the floor or otherwise normalize monetary policy was met with kicking and screaming from the financial markets. And every time, the Fed backed off, fearful that a loss of confidence would sink the still shaky economy. The one-and-done rate hike in December 2015 was the last best example.

That dynamic appears to be over. When asked whether the recent correction in the stock market might change the Fed's path to normalization, William Dudley, president of the New York Fed, said the fall was "small potatoes."

"They've put equity investors on notice that there's no more put option on the stock market from the Fed anymore," said Diczok at Merrill Lynch and U.S. Trust.

Last year the central bank hiked the Fed Funds rate three times, to 1.5 percent. It has telegraphed three more hikes this year, but with the economy exceeding expectations and unemployment at a 17-year low, many analysts now expect it could be four hikes.

"Inflation is still below 2 percent, but the confidence of the Fed in achieving the target is driving its policymaking," said BlackRock's Rosenberg.

Along with the Fed's rate hikes, the unwinding of the quantitative easing program could also push fixed-income yields higher in the coming year.

The Federal Reserve has been the biggest buyer of Treasury bonds and mortgage-backed securities for many years. Last September, however, it announced it would reduce the reinvestment of maturing bond proceeds by $10 billion per month and accelerate the pace of the unwind every three months. It now stands at $20 billion per month and will reach $50 billion by the fourth quarter.

If it sticks to the plan, it will reduce its bond purchases by roughly $420 billion this year. With government deficits rising and bond issuance increasing, that could pose a problem.

"With higher issuance from the government pushing up the supply of Treasurys and the Fed pulling back on demand, it will press on yield levels," said Rosenberg.

For his part, Diczok does not think the Fed will change its plans based on the government's funding needs. But he also doesn't think the supply-and-demand factors will lead to a big spike in yields.

"There's more than enough global demand for high-quality U.S. debt," he said. "I see no difficulty with the market absorbing more supply."

"Trade wars are good and easy to win." That's not something the market is used to hearing from a U.S. president. Trump's apparent desire to rewrite trade rules has been the biggest reason for volatility in the stock and bond markets. A war of retaliating tariffs with China and the European Union could seriously disrupt trade and hurt global economies — including the United States.

Diczok doesn't see the trade issue as a major risk to the economic upturn.

"We're not overly concerned with tariffs," he said. "We think the rhetoric comes down to negotiating tactics. The market is adjusting well to hearing things it's never heard before."

The other major downside risk to the global economy is the highly levered Chinese economy, where credit is overextended. A readjustment in the second-biggest global economy could hurt growth in the rest of the world.

The risk to the upside — higher growth, inflation and interest rates — is that the tax cuts and increased government spending overheat the economy. If the market sees the Fed behind the curve, interest rates could rise further and faster than expected.

A major factor countering that risk is low interest rates elsewhere in the world. U.S. interest rates are currently much higher than in Europe and Japan, and with neither the European Central Bank nor the Bank of Japan planning any rate hikes this year, foreign capital seeking higher returns could put a lid on rate rises here.

With rates rising and the spread between short- and long-term rates shrinking, both Diczok and BlackRock's Rosenberg favor shorter duration bonds in the Treasury market.

"The premium paid for tying up money for a longer period has shrunk," said Rosenberg. (The two-year Treasury bond now yields 2.25 percent.)

"It's low risk with an acceptable reward," he added. "For the first time in a long time, investors can get a real return in the short end."

With volatility increasing the stock market, investors may be able to tolerate a bear like that.

— By Andrew Osterland, special to CNBC.com