Fixed Income 2015 Update. Kathy Jones, Senior Vice President Chief Fixed Income Strategist, Schwab Center for Financial Research

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1 Fixed Income 2015 Update Kathy Jones, Senior Vice President Chief Fixed Income Strategist, Schwab Center for Financial Research

2 1 Fed: Slow and Low 2015 Fixed Income Outlook 2 Yield Curve Flattening 3 Higher Volatility 4 Mind the Gaps 2

3 The Fed Source: The Schwab Center for Financial Research 3

4 Gap 1: The Output Gap is Closing Billion Dollars $21,000 Dec. 29: Real Potential GDP Real GDP Projection $19,000 $17,000 A 3% growth rate will close the gap by end-2017 $15,000 $13,000 $11, Source: St. Louis Federal Reserve. Real Gross Domestic Product and Real Potential Gross Domestic Product, Billions of Chained 2009 Dollars, Quarterly, Seasonally Adjusted Annual Rate. Data as of Q

5 Gap 2: The Pace of Job Growth is Exceeding the Pace of Labor Force Growth Three month rolling average Percent change Yr/ Yr Payroll Growth Labor Force Growth Source: Federal Reserve Bank of St. Louis. All Employees: Total nonfarm and Civilian Labor Force, Percent Change from Year Ago, Monthly, Seasonally Adjusted. Data as of March

6 Employment Cost Index Total compensation: All Civilian Quarterly Percent change (Yr/ Yr) 3.0 Wages & Salaries: Private Industry Workers Workers wages rising the fastest since '15 Source: Federal Reserve Bank of St. Louis. Employment Cost Index: Wages & Salaries: Private Industry Workers and Total compensation: All Civilian, Percent Change from Year Ago, Quarterly, Not Seasonally Adjusted. Data as of Q

7 Gap 3: The Market and the Fed Still Far Apart Percent Fed Estimate (Mar-15) Market Estimate Dec-15 Dec-16 Dec-17 Longer Run Note: Expected Fed funds rate based on March 18, 2015 FOMC projections. Source: Federal Reserve Board, March 18, 2015 and Bloomberg Euro Dollar Synthetic Rate Forecast Analysis (EDSF) as of May 1,

8 Gap 4: U.S. Yields Far Above Other G-8 Yields Basis Points 10-year bond yield 2-year note yield U.S. U.K. Canada Italy France Germany Japan Switzerland Source: Bloomberg. Data as of May 1,

9 U.S. Dollar Index: 1971-present Two major bull markets for the dollar in recent history Index level 180 Feb. '85 (peak): Jan. '02 (peak): Bull markets Source: Federal Reserve Bank of St. Louis. Import (End Use): All commodities and Trade Weighted U.S. Dollar Index: Major Currencies, Percent Change from Year Ago, Monthly, Not Seasonally Adjusted. Monthly data as of May 1,

10 There is no average cycle Historically, the worst time period for bonds is 3 months before and 3 months after first rate hike. The yield curve eventually flattens when the Fed raises rates. With each cycle it has flattened earlier than the previous cycle. Long-term bonds are more volatile but can have higher returns over time. Source: The Schwab Center for Financial Research 10

11 Rate Hike Cycle: 1994 Fed funds rate rose from 3% to 6% from Feb-94 to Feb-95 Cumulative Total Return 15% Barclays U.S. Aggregate Bond Index 75% Barclays Aggregate, 25% Treasury Bills Barclays U.S. Long Treasury Bond Index 10% 5% 0% -5% -10% Aug-93 Oct-93 Dec-93 Feb-94 Apr-94 Jun-94 Aug-94 Oct-94 Dec-94 Feb-95 Apr-95 Jun-95 Aug-95 Source: Schwab Center for Financial Research and Barclays. Cumulative total returns, using monthly data, from August 1993 through July Two-year time horizon begins six months before the first rate hike. Returns assume reinvestment of interest and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results. 11

12 Rate Hike Cycle: 1999 Fed funds rate rose from 4.75% to 6.5% from Jun-99 to May-00 Cumulative Total Return 15% Barclays U.S. Aggregate Bond Index 75% Barclays Aggregate, 25% Treasury Bills Barclays U.S. Long Treasury Bond Index 10% 5% 0% -5% -10% Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Source: Schwab Center for Financial Research and Barclays. Cumulative total returns, using monthly data, from January 1999 through December Two-year time horizon begins six months before the first rate hike. Returns assume reinvestment of interest and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results. 12

13 Rate Hike Cycle: 2004 Fed funds rate rose from 1% to 5.25% from Jun-04 to Jun-06 Cumulative Total Return 20% 16% Barclays U.S. Aggregate Bond Index 75% Barclays Aggregate, 25% Treasury Bills Barclays U.S. Long Treasury Bond Index 12% 8% 4% 0% -4% Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Source: Schwab Center for Financial Research and Barclays. Cumulative total returns, using monthly data, from January 2004 through December Two-year time horizon begins six months before the first rate hike. Returns assume reinvestment of interest and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results. 13

14 Before changing your investments, consider where you are now. In cash? In long-term bonds? Start adding intermediate term bonds/bond funds to build a ladder. Add short-term bonds/bond funds to lower duration. Intermediate term/ladder? Do nothing/add short-term bonds, bond funds or cash. 14

15 Even in Bond Bear Markets, Negative Returns Have Been Rare, Annual total return for intermediate-term government bonds Annual Total Return Yield (%) 20% 16 15% % 10 5% 8 0% 6 4-5% 2-10% Source: Schwab Center for Financial Research with data from Morningstar, Inc. Data shown in the chart are annual total returns including price change and income for the Ibbotson U.S. Intermediate-Term Government Bond Index. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results. 15

16 Additional Resources For more SCFR commentary, access the fixed income research page at: Follow Kathy Jones on 16

17 Thank you 17

18 Index Definitions Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays U.S. Treasury Bond Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have USD250 million minimum par amount outstanding and at least one year until final maturity. Barclays U.S. Long Treasury Bond Index includes all public obligations of the U.S. Treasury, excluding foreign-targeted issues with maturates of 10 years or longer. US Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies. Morningstar Intermediate-Term Government: A fund with at least 90% of its bond portfolio invested in government issues with a duration of greater than or equal to 3.5 years and less than six years or an average effective maturity of greater than or equal to four years and less than 10 years. The Employment Cost Index (ECI) is a quarterly economic series detailing the changes in the costs of labor for businesses in the United States economy. The ECI is prepared by the Bureau of Labor Statistics (BLS), in the U.S. Department of Labor 2015 & Co., Inc. All rights reserved. Member SIPC 18

19 Additional Definitions Swap: Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps & Co., Inc. All rights reserved. Member SIPC 19

20 Disclosures Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and bond investments, when sold, may be worth more or less than original cost. Fixed income securities are subject to various other risks, including changes in interest rates and credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness. The views, opinions and estimates herein are as of the date of the material and are subject to change without notice at any time in reaction to shifting market conditions. The opinions presented should not be viewed as an indicator of future performance. Past performance is no guarantee of future results. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. The Schwab Center for Financial Research is a division of & Co., Inc & Co., Inc. All rights reserved. Member SIPC ( ) 20

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