Fixed Income Outlook  |  Q2 2021

Bond markets restless amid inflation hype

Fixed Income team

Bond markets restless amid inflation hype

  • U.S. Treasury yields trended higher, lifted by forecasts of stronger economic growth and inflation.
  • The Fed may start tapering bond purchases as soon as the first half of 2022, depending on Covid-19 cases and economic activity.
  • High-yield bonds and different parts of the mortgage market offer attractive investment opportunities.

Global financial markets were mixed during the first quarter. The bond markets experienced bouts of volatility, as yields jumped and demand eroded, reflecting expectations that Covid-19 vaccines and new stimulus money will boost the U.S. economy, lifting growth and inflation. The rate-sensitive Bloomberg Barclays U.S. Aggregate Bond Index fell 3.37% during the quarter. The ICE BofA 1–3 Year U.S. Corporate Index rose 0.02%. That compares with a gain of 6.17% for the S&P 500 Index.

The Federal Reserve has pinned short-term interest rates near zero since early 2020. Fed officials in March highlighted an improved outlook for U.S. growth but signaled they expect to maintain ultralow interest rates through 2023. U.S. fiscal stimulus, including President Biden's $1.9 trillion package, has added tailwinds to the economy. Central banks across Europe, Asia, and other regions have also maintained easy money policies. Covid-19 cases have ebbed and flowed across the globe, with some governments reopening and others reimposing lockdown measures.

Long-term U.S. Treasury yields have risen sharply in recent months. The yield on the benchmark 10-year Treasury note surged as high as 1.78% in March before falling to 1.74% at quarter-end. That rate was below 1% for much of 2020. The yield on the 2-year note ended the period at around 0.16%. Higher long-term interest rates placed a degree of pressure on the credit market, including investment-grade bonds and emerging-market debt. Within this environment, high-yield credit outpaced the broad investment-grade debt market, aided by better-than-expected corporate earnings and higher oil prices.

Fed downplays the risk of inflation

The Fed has left the federal funds rate at 0.00% to 0.25% since March 2020. The Fed also pledged to continue purchasing at least $120 billion of Treasury bonds and mortgage-backed securities monthly. Fed Chair Jerome Powell in March said the measures "will ensure that monetary policy will continue to deliver powerful support to the economy until the recovery is complete." Concerns about the potential inflationary impact of additional stimulus on top of an already-recovering economy have led to speculation that the Fed may lift short-term rates or start tapering its bond-buying program. Powell, however, has said any pickup in inflation will be transitory.

The Fed expects the economy to grow 6.5% this year and 3.3% in 2022, and the unemployment rate to fall to 4.5% by the end of 2021. Central bank officials have also raised projections for inflation rate for personal-consumption expenditures (PCE) to 2.4% this year and 2% in 2021. But the Fed hasn't said how long it would allow inflation to run above 2%. Against this backdrop, consumer confidence in March soared to a one-year high. Job growth picked up in March, and the jobless rate fell to 6% after peaking at almost 15% in April 2020.

We believe the Fed may announce tapering in the second half of 2021 if Covid-19 cases don't take a turn for the worse and economic activity improves. Tapering of asset purchases – which is a form of monetary tightening - could start as soon as the first half of 2022. As for raising the policy rate, the Fed might stay patient until there is substantial progress in the labor market. The Treasury yield curve has steepened in response to no hike projections in 2023. The Fed can control the front-end of the curve but not the back end.

ECB pledges higher pace of bond purchases

The European Central Bank (ECB) said in March it plans to increase its bond purchases in the second quarter of 2021 to contain the impact of global rising yields in the eurozone. While policy makers committed to front load purchases, it kept the Pandemic Emergency Purchase Program (PEPP) at 1.85 trillion euros until at least the end of March 2022. Yields in the eurozone had trended higher since February – following a rise in U.S. Treasury and global government bond yields – leading to worries that it could derail the region's economic recovery. The ECB's decision to accelerate bond buying has pushed European yields lower, widening the spread between European and U.S. sovereign bond yields. Germany's 10-year bond yields, seen as the benchmark for Europe, tumbled to -0.313% as of early April after climbing in February.

ECB President Christine Lagarde said the Covid-19 pandemic continues to pose a risk to the eurozone's economy. Consumers in the region also remain cautious about the outlook, as some countries in the EU remain in lockdown and others have strict social-distancing restrictions still in place. In addition, the rollout of Covid-19 vaccines has been slow. This could add further pressure on the 19 eurozone economies. The ECB in March forecast that gross domestic product (GDP) in the eurozone would rise by 4% this year and 4.1% in 2022.

Rates remained anchored on the front end as intermediate and long-term rates rose and the curve steepened

China leaves benchmark lending rates unchanged

Recovery in the world's second largest economy has picked up speed, boosted by domestic consumption and foreign demand for Chinese-made goods. The official manufacturing purchasing managers index, a gauge of factory activity, hit a three-month high of 51.9 in March, according to data by the National Bureau of Statistics. The official nonmanufacturing PMI also surged in March. China's economy expanded by 2.3% in 2020 as the government rolled out a raft of stimulus measures, including tax relief and cuts in banks' reserve requirements. The government set its target for 2021 growth at "above 6%."

The People's Bank of China (PBoC) in March kept its benchmark lending rate unchanged. The one-year loan prime rate (LPR) was at 3.85%, while the five-year LPR remained at 4.65%. PBoC Governor Yi Gang reiterated a pledge that policymakers want to balance providing support for growth while reducing financial risks. The central bank still has room to pump liquidity into the economy. Chinese bonds continue to attract investors. The 10-year government bonds yielded around 3.2% compared with about 1.7% for the 10-year U.S. Treasury. The yuan has surged in strength in recent months against the dollar and other major currencies.

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