- U.S. Treasury yields trend higher as the Fed plans to tiptoe away from asset purchases.
- We believe the environment for fixed-income securities remains relatively supportive.
- As the clock ticks on debt ceiling talks, we will continue to monitor how short-term bond markets react.
Global financial markets were mixed during the third quarter. Fixed-income markets faced volatility from multiple directions, including the Federal Reserve's announced intention to taper monthly bond purchases, the expiration of the U.S. federal debt limit, the shifting outlook for growth, and the spread of Covid-19 variants. China's real estate woes also kept investors on edge. Markets have taken a slight risk-off turn as the global recovery from the pandemic slows, in our view. The rate-sensitive Bloomberg U.S. Aggregate Bond Index rose 0.05% during the quarter. Global bonds, as measured by the FTSE World Government Bond Index, declined 1.24%. That compares with a gain of 0.58% for the S&P 500® Index.
Central banks around the world have started to raise interest rates or revealed plans to roll back easy monetary policies. In late September, the Fed signaled it was poised to begin scaling back asset purchases as soon as November. Half of the Fed's 18 policymakers expect to lift interest rates from near zero in 2022, according to updated economic projections. The European Central Bank (ECB) also said it would conduct bond purchases under its emergency program at a "moderately lower pace" over the next few months. President Biden's $1.2 trillion bipartisan infrastructure bill — already passed in the U.S. Senate — has been held up in the House of Representatives. How all these factors, including the fate of the U.S. debt ceiling, play out will determine the market's medium- and long-term direction.
Global bond yields have continued their upward trend, pushed higher by the Fed's hawkish surprise on its policy path. The yield on the benchmark 10-year U.S. Treasury note topped 1.5% in late September, its highest since June, and ended the quarter at 1.49%. The yield on the 2-year note ended the period at around 0.28%, up slightly from 0.25% at the end of June. Investment-grade corporate bonds finished the quarter flat. High-yield credit bucked the trend even though yield spreads widened modestly. (Spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity Treasuries.)
Fed prepares to curtail asset purchases
Fed Chair Jerome Powell said the bond-buying program may come to an end by the middle of 2022. Officials, however, are also evenly split on whether to raise the federal funds rate in 2022, according to the median estimate of FOMC participants. In June, the dot-plot indicated no rate increases until 2023. But the Fed left the benchmark short-term interest rate anchored near zero, where it has been since March 2020. The U.S. rates market rose following the Fed meeting. The central bank is buying $120 billion a month in Treasury bonds and mortgage-backed securities to hold down long-term rates. We will continue to monitor how the short-term markets, including Treasury bills and repos, react over the next few months. Congress' challenge to raise the federal debt limit made headlines. Lawmakers passed legislation in early October to raise the debt ceiling through early December.
The Fed expects the economy to grow 5.9% this year from the 7.0% estimate in June. Central bank officials have also raised projections for personal consumption expenditure (PCE) inflation to 4.2% this year — above its 2% goal — from 3.4% in June. Economic recovery, pandemic-related labor shortages, and supply bottlenecks have been driving price gains. Consumer prices rose 5.3% for the 12 months ending in August, down slightly from 5.4% in July, according to the Labor Department. Against this backdrop, job growth slowed in September, but the unemployment rate fell to 4.8%. The Fed sees the unemployment rate for the year at 4.8%.
ECB slows bond purchases but holds rates steady
In September, the European Central Bank left its policy rate unchanged. But the ECB opted to slow the pace of bond purchases under its pandemic emergency purchase program in the final three months of this year. The program has been buying about 80 billion euros of mostly government bonds each month. ECB president Christine Lagarde, however, downplayed inflation risks, noting that the current increase in inflation is expected "to be largely temporary."
The Bank of England (BoE) has also signaled its intention to gradually unwind crisis-era aid. BoE Governor Andrew Bailey said interest rates could increase as soon as this year, even before its bond-buying program expires. The aggressive tone by the BoE led to a sell-off of government bonds and a sharp rise in yields across Europe during the third quarter. It also places the BoE among the more hawkish central banks in the developed world. The yield on U.K. 10-year notes rose above 1% — for the first time since March 2020 — to about 1.163% in early October. Germany's 10-year bond yields, seen as the benchmark for Europe, rose to -0.148% in early October from -0.605% at the beginning of the year.
Treasuries rallied to start the quarter, but reversed course as the taper discussion heated up later in the quarter
Source: U.S. Treasury Department. Past performance is not indicative of future results.
China seeks to avoid "flood like" stimulus
China's crackdown on property developers, technology behemoths, and other private companies has weighed on domestic and global markets. This comes in the wake of a debt crisis facing real estate company Evergrande Group. New restrictions on travel have also hurt consumer spending, while manufacturing has been bit by rising costs, production bottlenecks, and electricity shortages. The official manufacturing Purchasing Managers' Index (PMI) was at 49.6 in September versus 50.1 in August, data from the National Bureau of Statistics showed. China's economy grew 7.9% in the second quarter from a year ago, compared with a record 18.3% in the first quarter.
In August, People's Bank of China (PBoC) Governor Yi Gang said the central bank will keep monetary policy stable. And in early September, Deputy Governor Pan Gongsheng said the bank plans to avoid "flood like" stimulus. At the same time, the central bank ramped up support to small businesses by providing lost-cost funding to banks. The PBoC cut the reserve requirement ratio, the amount banks need to hold on reserve, in July. However, the central bank has kept the loan prime rate and policy rates steady since lowering them in early 2020. China's benchmark sovereign bond yield has seesawed in recent weeks, with the 10-year notes yielding around 2.92% in early October.
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Fixed-income markets faced multiple risks, including the Fed's plan to unwind debt purchases, the shifting growth outlook, and Covid-19. But, we believe the environment for bonds remains supportive.