Fixed-income investors have been on a market roller coaster with jarring volatility in recent years. This trend was clearly exemplified by the Covid pandemic. But after the trying, and sometime harrowing, times, the major markets have still posted solid returns on average.
In that regard, navigating the era of the Covid recovery isn’t entirely new territory. Yes, the most recent rise in rates has taken a bite out of bond market returns, but is the long-running bull market now ending? In our view – and based on the asset returns – the answer is a resounding “no”.
Once we are beyond the peak momentum of the Covid recovery, it should become clear that the current rise in yields is a harbinger for a rotation of return drivers in the bond market. Returns from credit risk – the primary driver of bond returns over the last year—will likely continue, but not as strongly as before. Meanwhile, duration, which has been an overall headwind for the bond market in 2021, should become a positive contributor once yields top out. At that point, newly steepened yield curves will likely support carry and roll-down as return drivers with the potential for price appreciation as well if yields retrace from their recent increase.
Key #1 to the Low-Rate Hypothesis: Contained Inflation
Inflation and inflation expectations are key to the bond market outlook for two reasons. First, looking at the inflation-linked bond market, we can see that investors’ inflation expectations directly impact nominal bond yields. In fact, the rise in market inflation expectations (or breakevens) more than account for the climb in nominal Treasury yields over the past year. The observable shift demonstrates how rising inflation expectations have tended to coincide with peaks in nominal rates and have frequently signaled the start of bullish periods for bonds.
Second, inflation is inexorably linked to central bank policy: if inflation rate remains below target, then the central bank is likely to keep the policy rate at the effective lower bound.
Key #2 to the Low-Rate Hypothesis: DM Central Bank Policy
Central bank policy is critical because it anchors the front end of the yield curve and increasingly guides expectations for the future path of the central bank’s administered rate. The 10-year yield can be found right in line with the Fed’s forward guidance.
However, markets have diverged from the Fed’s indicated path amid the ongoing recovery from the pandemic. Market-determined rates, such as the 10-year Treasury yield, have risen substantially even though the Fed funds rate is expected to remain at zero until 2023. Ultimately, as any above-inflation pressures likely diminish, rather than mushroom, and the pace of economic growth levels off, the Fed – and most DM central banks for that matter – will likely continue guiding policy rates on a very low track.
We expect the US 10-year Treasury yield to remain below 2% as the expansion continues this year, before dropping back to 1.25% or even 1% after economic momentum crests. Furthermore, variations of this patten will seem to repeat across most DM markets.
The outlook for spread product carries some caveats: first, the relatively narrow level of spreads will likely diminish the pace and magnitude of further outperformance. Additionally, narrower spreads leave little room for error and warrant stringent credit selection in order to avoid blow-ups and hot spots. In terms of currencies, the foreign exchange markets may be ready for a change as well: in the second quarter the dollar could take a breather as the rollout of vaccinations and growth outside of the US gather pace.