Fixed Income Outlook  |  Q4 2020

Bond investors face Catch-22

Putnam Investments

Bond investors face Catch-22

  • We expect bond yields to stay near record lows amid an uneven economic rebound and the November election.
  • The Fed signals a shift for setting its monetary policy, allowing for a rate environment that will likely be "lower for longer."
  • We have a fairly favorable outlook for the bond markets, including investment-grade corporate bonds.

Global financial markets trended higher during the third quarter. The rally was fueled by ongoing stimulus policies, signs of economic revival, and progress toward a COVID-19 vaccine. The market's resilience also benefited bondholders. The rate-sensitive Bloomberg Barclays U.S. Aggregate Bond Index advanced 0.62% during the quarter. The ICE BofA 1–3 Year U.S. Corporate Index rose 0.74%.

In August, the Fed announced a new monetary policy framework that will essentially abandon its longtime strategy of preemptively lifting rates to head off higher inflation. The Fed's shift in how it sets rates indicates the central bank will tolerate "lower for longer" interest rates. Central banks across Europe, Asia, and other regions also rolled out COVID-19 stimulus measures.

That said, the world's top economies — including the United States, France, Germany, Japan, and the United Kingdom — shrank dramatically in the first half of 2020. This indicates the global economy may struggle to return to pre-pandemic levels of output until a vaccine becomes widely available.

Yields on U.S. government bonds have stalled near all-time lows. The yield on the benchmark 10-year Treasury note ended the quarter at 0.69 % from 1.88% at the beginning of the year. The 2-year note yield tumbled to around 0.13% at quarter-end. The market for high-yield and investment-grade corporate bonds continued to recover as spreads, or the risk premiums over Treasuries, narrowed during the period. We have a fairly favorable outlook for investment-grade corporate bonds, and we are also finding opportunities in high-quality securitized assets, including AAA-rated asset-backed securities. The commercial mortgage-backed securities (CMBS) market, however, is coming back haltingly.

The Fed's new policy and the U.S. economy

Fed officials expect to leave rates near zero for years — through at least 2023 — as they try to coax the economy back to full strength after the pandemic-induced recession. The Fed continues to pump trillions of dollars into the financial system. We believe the central bank's backstop remains supportive for credit spreads and reduces the probability of another liquidity driven sell-off. We think Treasury yields will remain low across the curve for an extended period. The Fed also signaled that it will be more inclined to allow inflation to rise modestly above the 2% target. Chair Jerome Powell said the bank's new strategy could be viewed as "a flexible form of average inflation targeting."

The economy continues its halting recovery from the sharp decline in the second quarter. The service and manufacturing sectors reported solid growth in September, and the unemployment rate declined, but hiring gains cooled. The jobless rate fell to 7.9% in September from 8.4% the prior month, a Labor Department report said. Consumer spending is also rising at a slower pace than pre-pandemic levels. We believe the risk of renewed widespread lockdowns is low. That said, we remain skeptical about a "V-shaped" recovery. A sharp downturn followed by a quick rebound in growth defines the V-shaped recovery.

Politics will take center stage over the next few months. The presidential election campaigns have kicked into full gear ahead of the November 3 vote amid fresh uncertainty after President Trump tested positive for COVID-19. Investors are also bracing for gridlock on a new fiscal stimulus package. Democrats and Republicans have been at an impasse over the next virus relief bill. Our view is the economy and risky assets will struggle in the absence of a new round of stimulus. Against this backdrop, the Fed expects the economy to contract by 3.7% this year, before bouncing by 4% in 2021.

EU adopts groundbreaking stimulus plan

The recovery has been slower in many parts of Europe because of the resurgence of the virus. The weakening of service sectors in September came as a number of European countries, including the United Kingdom, France, and Spain, tightened restrictions in response to accelerating infection rates. Manufacturing, however, is bounding back in some countries. In Germany, the region's largest economy, the private sector continued to recover as foreign demand provided a boost to manufacturing. The European Union (EU) predicts the bloc's economy will shrink by 8.7% this year and grow by 6.1% in 2021.

In July, the EU agreed to create a €750 billion recovery fund, including selling collective debt. The European Central Bank (ECB) is also doing its bit to help, with an expansion and extension of its quantitative easing program at least until June 2021. The bond purchases by the ECB have kept yields on government debt in the region pinned extremely low, especially for riskier borrowers such as Italy. In the United Kingdom, finance minister Rishi Sunak unveiled another £30 billion stimulus package aimed at stemming the growing jobs crisis and lifting the economy out of its worst slump in centuries.

Rates stayed mostly range bound during the quarter across a relatively flat curve, as investor sentiment remained risk-on

China's bond market attracts investors

China's recovery makes it an outlier as the pandemic weighs on the rest of the globe. The economy, which contracted 6.8% in the first quarter, grew 3.2% in the second quarter from a year earlier as lockdown measures ended, and policymakers stepped up stimulus measures. Manufacturing and services sectors have shown signs of recovery, but private consumption and retail sales remain weak. China has rolled out a raft of measures, including tax relief and cuts in banks' reserve requirements. The economic momentum and easing concerns about U.S. tariffs have spilled over to the currency and the bond markets.

Relatively high interest rates, plus a broader sell-off in the dollar, have buoyed the yuan. The People's Bank of China — which tightly controls the currency's movements — appears more comfortable in letting the currency join a broader rally against the dollar. A widening gap between interest rates in the United States and higher rates available in China is also boosting government bonds. Foreign purchases of Chinese bonds hit a record in the second quarter as investors sought higher yields. The benchmark 10-year bond yielded around 3.16%.

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