Top Bond Fund Manager Warns: 'Prepare For More Market Turbulence'

Federal Reserve Chairman Jerome Powell was very clear last week that he and his peers on the FOMC will continue to raise interest rates next year - even if the pace of rate hikes could be somewhat slower than previously anticipated. And while equity investors were quick to take him at his word - sending the S&P 500 8% lower and bringing the longest bull market in history to a sensational end - bond traders have been somewhat more reluctant.

Indeed, a selloff that began back in September with short-term yields breaking to heights unseen since the crisis ended with Treasury yields moving back below these key psychological levels, with the 30-year below 3% and the 10-year trading at 2.8%. Unsurprisingly, these moves have accompanied expectations that the Fed's own dot plot is far too optimistic and that, in the market's view, a rate hike next year is about as likely as a rate cut.

Rates

This probably offered some relief to Treasury Secretary Steven Mnuchin, who tried (and failed) to convince investors that the market overreacted to Powell last week. But any respite from the looming threat of higher interest rates could be short-lived - or at least that's what Michael Hasenstab, chief investment officer for Franklin Templeton’s global bond funds, expects.

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Michael Hasenstab

While chaos in the equity market has kept rates subdued during the final trading weeks of the year, Hasenstab believes it's only a matter of time before investors realize that the Fed can't stop/won't stop hiking rates and shrinking its balance sheet. Once the market finally comprehends the true breadth of the looming interest rate risk, Hasenstab expects yields to shoot higher - the 10-year yield should top 4% by the end of 2019 - putting even more pressure on equities as the "Shocktober" market dynamic reemerges.

Hasenstab described his market outlook during an interview with the Financial Times.

"October was not a fluke," Hasenstab said. "There is a lot of entrenched interest rate risk in all financial markets right now."

But even if raising interest rates leads to some discomfort in the short term, the Fed should keep hiking, because "it's the right thing to do."

"I don’t know what they will do, but I know what they should do, and that is to keep raising rates," he said. "It is better to have these periodic downturns than procrastinating and have to move even more aggressively later on."

Hasenstab's $35 billion Templeton Global Bond Fund is up 1.6% on the year, compared with a 2.2% loss for the global bond market, thanks to aggressive bets against the euro and US equities. Judging by Hasenstab's outlook, if his view proves correct, those trades should continue to generate profits during the new year.