What’s worse, if the economy remains strong, there is a good chance that yields will move higher. That is a problem for fixed-income investors because rising bond yields mean falling bond prices. For people holding bond mutual funds and exchange-traded funds, total return is a combination of yield and price. It all makes it less likely that core bond funds — those that focus on high-quality securities — will be able to match the 3.7 percent average gain for 2017, which was 1.5 percentage points ahead of the inflation rate.
“We are in a transition market,” Mr. Bhatia said.
As evidence, consider that the difference between short and long-term rates is less than it has been since 2007. In bond market parlance, the yield curve has flattened.
Why has this happened? Shorter rates are being pulled upward by the Federal Reserve from the near-zero level that the Fed instituted during the financial crisis.
Longer term rates, on the other hand, are constrained by the expectation that inflation will remain very low in 2018.
Rick Rieder, global chief investment officer of Fixed Income at BlackRock, says inflation could surprise the market next year. It is possible that a falling unemployment rate at a time of solid economic growth could put ample pressure on wages that would, in turn, raise inflation off the floor. “I think we can get to 2 percent,” Mr. Rieder said. The Federal Reserve’s preferred inflation measure has crawled along below 1.5 percent since the financial crisis.
A 2 percent inflation rate would most likely just nudge long-term rates higher, he said, adding that he expects a “slow and low trajectory” for long-term rates. His base case is that the 10-year Treasury rate, now at about 2.5 percent, won’t rise much beyond 2.7 percent.
Unless inflation surges unexpectedly, a 3 percent yield for the 10-year Treasury note may not be likely. Julien Scholnick, a fixed income manager at Western Asset Management, which manages $435…