Fixed Income Outlook  |  Q3 2020

Bonds ride the Fed wave as volatility returns

Putnam Investments

Bonds ride the Fed wave as volatility returns

  • We expect short-term interest rates to remain near record lows this year and yields to stay range bound.
  • The Fed’s facilities have increased liquidity in the markets and, in turn, stabilized bond spreads.
  • We have a fairly favorable outlook for the fixed-income markets, including investment-grade corporate bonds.

Global financial markets proved to be surprisingly resilient during the second quarter. The snapback in investor sentiment and price levels across asset classes was fueled by fiscal and monetary stimulus, along with the first steps of an economic recovery as businesses began to reopen around the world. The S&P 500 Index, a broad measure of stocks, rose 20.54% and the MSCI World Index gained 19.36% during the period. The market’s resilience has also benefited bondholders. The rate-sensitive Bloomberg Barclays U.S. Aggregate Bond Index advanced 2.90% during the quarter. The ICE BofA 1–3 Year U.S. Corporate Index advanced 4.39 % for the period.

Interest rates remained range bound. The yield on the benchmark 10-year Treasury Note ended the quarter at 0.66% compared with 0.70% on March 31. Corporate credit — both investment-grade and high-yield — advanced and spreads tightened, mirroring the strength seen across equity markets. The Federal Reserve (Fed) cut interest rates to near zero in mid-March, and unleashed a torrent of bond-buying programs to ensure smooth market functioning. The U.S. Congress has also pumped trillions of stimulus dollars into the economy. Central banks across Europe, Asia, and other regions also rolled out COVID-19 stimulus measures. Against this backdrop, we have a favorable long-term outlook for investment-grade corporate bonds and some sectors within mortgage-backed securities. The commercial mortgage-backed securities (CMBS) market, however, has faced significant headwinds caused by the pandemic.

As we head into the second half of the year, we expect COVID-19 and the economy will continue to dominate headlines. Investors are bracing for a worldwide recession and a second wave of the coronavirus outbreak. Fed Chair Jerome Powell signaled in June that the central bank plans to keep rates near zero for “as long as it takes to provide some relief and stability.” Therefore, we expect short-term rates to remain near record lows this year. The U.S. economy has entered a recession — bringing the 11-year expansion to a halt — as the pandemic caused economic activity to slow sharply. A recovery, once it comes, will likely be slow and halting, and punctuated by brief periods of faster growth.

U.S. recovery unlikely to be “V-shaped”

The economy is showing early signs of stabilization. U.S. manufacturing rebounded in June as major parts of the country opened up, ending three months of contraction; consumer spending surged in May although it remains below pre-pandemic levels, and unemployment fell in June. U.S. employers added about 4.8 million jobs in June and the unemployment rate fell to 11.1% from 13.3% in May, according to the Labor Department. However, the economy’s position is a bit tricky because of the recent surge in coronavirus infections.

As states ease mobility restrictions, there is a second wave of COVID-19 in a large number of places such as Florida and Texas. This poses a threat to private sector confidence and the pace of the recovery. The interaction between public health policies and the private sector’s reaction is at the heart of the outlook for these states and the economy. We don’t expect households will return to more normal patterns of consumption while the virus is circulating so freely. The Fed expects the economy to contract by 6.5% this year, before rebounding by 5% in 2021. Policymakers also expect the unemployment rate to be 9.3%, before falling to 6.5% in 2021. We continue to think a “V-shaped” recovery is very unlikely.

A proactive Fed

Since March, the Fed has cut its short-term rates to a target range of 0% to 0.25% and has pumped trillions of dollars into the financial system. The central bank has introduced a range of emergency lending programs to purchase debt of companies, cities, and states in a bid to encourage banks to keep lending and prevent a market collapse. In June, Fed officials signaled plans to keep interest rates near zero through at least 2022. Minutes released from the June meeting indicate officials remain worried about the bounce in consumer spending, business activity, and unemployment.

Given the overwhelming policy response, we think Treasury yields will remain low across the curve for an extended period. The 10-year Treasury yield plunged to an all-time low of 0.31% on March 9 and ended the quarter at 0.66%, after starting the year at 1.88%. The 2-year note yield tumbled to around 0.16% at quarter-end. As the economy enters the second half of the year, we believe the Fed will need to step in with more policy support as the initial phase of growth fades. Whether that will be through more explicit yield-curve control or an expansion of its quantitative easing (QE) program isn’t yet clear. With QE, the Fed will buy Treasury bonds and other securities to keep borrowing costs low and help markets function properly.

European Central Bank expands bond buying program

Cyclically, the eurozone looks to be in a decent place. Although no one is out of the woods yet, recoveries are slowly underway. Germany agreed on a sweeping €130 billion stimulus package designed to spur short-term consumer spending and get businesses investing again. There are also some encouraging signs in France, but Spain is lagging quite badly. The virus data also continues to be better in Europe. Reopening has seen isolated pockets of resurgence, but they have so far been contained. The European Union (EU) is still working on the details of its burden sharing program that includes a €500 billion recovery fund.

Rates were mostly range bound during the quarter across a relatively flat curve, amid widespread risk-on-sentiment

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. In early June, the central bank increased its Pandemic Emergency Purchase Program by €600 billion. That comes on top of €750 billion of government bond purchases announced in March. These steps are more aggressive than expected, and while they are not game changers, they are helpful. In the United Kingdom, the Bank of England and the government are ramping up stimulus measures to lift the economy from one of its worst downturns. The central bank increased the target for its bond-buying program to £745 billion.

China’s stimulus firepower

As mobility restrictions have eased in China, economic activity has been gathering momentum. A raft of recent data has shown the upturn, including manufacturing activity and consumer spending. The manufacturing purchasing managers index climbed to a three-month high of 50.9 in June from 50.6 in May, according to the National Bureau of Statistics. The separate non-manufacturing PMI, a gauge of services and construction activity, jumped to a seven-month high. Still, keep in mind the actual level of activity remains far below pre-virus levels and the recovery in demand remains slow. Increased spending will also continue to increase debt levels. The Chinese economy shrank 6.8% in the first quarter from a year earlier.

Chinese policymakers have also adopted accommodative measures to boost growth. In April, the People’s Bank of China (PBoC) cut its benchmark lending rate to reduce borrowing costs for companies. The one-year loan prime rate was lowered to 3.85% from 4.05% previously. The yuan has strengthened to levels last seen in March, and PBoC has so far sent strong signals that it does not want to see pronounced currency volatility. Periodic bursts of renminbi weakness have the potential to send shock waves around the global financial system.

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