I’m going to paraphrase a hippy-dippy poster I saw in a high school counselor’s office back in the early 1980s: “What if the Fed raised rates and yields did nothing?” That happened, so everyone bought stocks and held on to their bonds.

The Federal Reserve hiked its benchmark federal funds rates three times during 2017, and it now stands in a range from 1.25% to 1.50%. This is a gigantic move in the short-term rate world seeing as the fed funds rate was more or less zero for a multi-year period.

So how did bonds react? Here’s a chart of 10-year U.S. Treasury yields.

While the Treasury yields did trade in a range that approached 100% from around 1.5% to nearly 3% over the last five years, the actual trend, based on its consistency, is a mere 50 basis point swing from 2% to 2.5%, for only 25%. This is probably the best indicator of where bond yields are going, or not going, in 2018.

Here’s why…

#-ad_banner-#1. It’s The Economy, Stupid! 
Coined by Bill Clinton campaign strategist James Carville, this phrase is probably one of the best descriptors for explaining, well, just about anything, but especially financial markets. Markets go down, the economy is weakening. Markets go up, the economy is or will be improving. Granted, sometimes it may be a lagging indicator. However, the “Big E” plays a leading role. 

The current U.S. economic picture is extremely encouraging. As real GDP growth approaches the 3% nirvana, the jobless rate continues to fall. Some forecasts project the that the unemployment rate could fall to 3.7%, the lowest since the 1960s. Core inflation has stayed low, scraping slightly above 2% where it has been through most of the decade. Higher inflation usually brings higher rates and yields along for the ride. But that doesn’t exist now.

While the economic picture is rosy, the indicators tell us that we are, most likely, towards the latter stage of the growth cycle. This doesn’t necessarily mean we are headed for another recession. However, an economy that has completed most of its expansion is less likely to push rates higher. It’s almost as if the market isn’t paying attention.

2. Slow Motion 
After employing its system-saving (yes… I firmly believe that) quantitative easing program, the Fed’s balance sheet ballooned from $870 billion to over $4 trillion. Eventually, the central bank would need to unwind that. That time has come. 

But it’s not as scary as it sounds. The Fed is shrinking its balance sheet organically in that when securities they’ve purchased mature, the proceeds are not reinvested. This is being accomplished at a $50 billion clip every quarter. This keeps the bond market level and gives the central bankers dry powder (cash) in the event of another crisis. Selling its holdings in the open market would create financial chaos of epic proportions. I’m fairly confident the Fed heads aren’t dumb enough to do that. But you never know.

Action To Take: So, with rates set to go virtually nowhere (and that’s a good thing) where do income investors go? Cue my broken record prop.

Treasuries and high-quality, long-maturity corporate bonds are poor choices for one obvious reason: they’re still highly susceptible to principle fluctuation risk. Even though rates are by no means set to rocket sky high, a 25% swing in 10-year rates will cause some price erosion.

Yield oriented investors would be best served nibbling at the following:

1. Reasonably priced, dividend-paying blue-chip stocks with yields of 100 bps (1%) or more over the 10-year treasury. 

2. Quality closed-end funds trading at discounts to their net asset value (NAV). 

3. Fairly priced energy master limited partnerships (MLPs) focused on storage and pipelines (these are set to benefit from the new tax law). 

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