Fixed Income Outlook  |  Q3 2021

Bond markets in flux on rates and inflation outlook

Michael V. Salm, Chief Investment Officer, Fixed Income

Bond markets in flux on rates and inflation outlook

  • Long-term U.S. Treasury yields slipped and short-term rates rose, as investors mulled growth and inflation.
  • We believe the environment for fixed-income securities remains generally supportive.
  • The Fed has adopted a more hawkish tone on interest rates and higher inflation expectations.

Global financial markets were mixed during the second quarter. Fixed-income assets came under pressure periodically due to concerns that rising inflation and a speedy economic recovery could prompt central bankers to pare back easy money policies. But markets have stabilized as the pandemic shows signs of tailing off in parts of the world and fiscal stimulus continues to buoy growth. The rate-sensitive Bloomberg Barclays U.S. Aggregate Bond Index rose 1.83% during the quarter. Global bonds, as measured by the FTSE World Government Bond Index, rose 0.98%. That compares with a gain of 8.55% for the S&P 500 Index.

In mid-June, the Federal Reserve signaled that it expects to raise short-term rates by late 2023, sooner than previously anticipated. The Fed also said officials had discussed an eventual tapering of bond-buying programs. Some central banks across Europe and Latin America have already started to lift rates. But the European Central Bank has pledged to maintain easy money policies. Against this backdrop, President Biden is indicating support for a $1.2 trillion spending package to invest in the nation's infrastructure, adding fuel to the economic recovery. The U.S. economy grew at an annualized rate of 6.4% in the first quarter.

Yields on longer-dated U.S. Treasuries have broadly trended lower this quarter since peaking in March. The yield on the benchmark 10-year Treasury note slipped to 1.45% at quarter-end from 1.74% at the end of March, while the yield on the 30-year Treasury fell from 2.41% to 2.06%. The yield on the 2-year note ended the period at around 0.25%. Investment-grade bonds managed to recover from losses suffered in the first quarter to post positive performance. High-yield corporate credit did even better, as yield spreads continued to narrow. [Spreads are the yield advantage credit-sensitive bonds offer over comparable-maturity Treasuries].

Fed signals shift in easy money policies

Fed policymakers expect to make two interest-rate increases by the end of 2023, according to the central bank's updated economic projections in June. But they left the benchmark short-term interest rate anchored near zero, where it has been since March 2020. The Fed also pledged to continue buying about $120 billion a month in Treasury securities and other government-backed bonds. The Treasury yield curve flattened, and real rates rose following the Fed meeting. Overall, we believe the environment for risk assets remains generally supportive. Considering expectations for sturdier growth, we believe Treasury yields could rise further this year. That said, we think the trend toward higher rates will be gradual as bond investors adjust their growth and inflation outlooks, leading to periods of market volatility.

The Fed expects the economy to grow 7% this year from the 6.5% growth estimate in March. Central bank officials have also raised projections for personal consumption expenditure (PCE) inflation to 3.4% this year — above its 2% goal — from 2.4% in March. This comes as the economic recovery is driving consumer prices to the highest levels in nearly 13 years. The consumer price index surged 5.4% in June, the fastest rate since 2008, according to the Labor Department. Fed Chair Jerome Powell said the spike in prices will likely abate and was largely being driven by pandemic-related issues. Against this backdrop, job growth picked up in June, but the unemployment rate rose to 5.9%. The Fed sees the unemployment rate for the year unchanged at 4.5%.

ECB pledges to keep policy steady

The European Central Bank (ECB) said in June it plans to maintain its "very accommodative" monetary stance. The ECB left the policy rate unchanged but has increased the pace of asset purchases while keeping the Pandemic Emergency Purchase Programme (PEPP) at 1.85 trillion euros until at least March 2022. Eurozone government bond yields ticked higher during the second quarter amid expectations of rising inflation, the Fed's more hawkish tone on rates, and worries about the ECB's stance on policy. Germany's 10-year bond yields, seen as the benchmark for Europe, rose to a high of -0.074% in mid-May before settling at -0.203% at the end of June.

The ECB in June also forecasted a stronger growth outlook and higher inflation in the region. The eurozone economy is expected to grow 4.6% this year compared with a 4% forecast in March. Inflation is expected to spike at 1.9% in 2021, driven by temporary upward factors, before returning to 1.5% in 2022. ECB President Christine Lagarde said in June that policymakers are more optimistic about the recovery even as the pandemic continued to weigh on the bloc's economy. Lagarde added that it was too soon to discuss tapering bond purchases and that premature tightening in rates poses risks to growth and inflation. In our view, if there are no Covid-19-related hiccups in the fall and inflation stays elevated, the ECB Governing Council will probably start debating the end of PEPP in or after March 2022.

Rates sold off on the front end as intermediate- and long-term rates rallied and the curve flattened

China seeks more targeted and flexible monetary policy

The world's second-largest economy is rebounding strongly from the impact of the Covid-19 pandemic, boosted by exports. But the recovery in the consumer spending and factory activity has slowed. The official manufacturing purchasing managers' index (PMI), a gauge of factory activity, eased slightly to 50.9 in June versus 51.0 in May, data from the National Bureau of Statistics showed. The official nonmanufacturing PMI also dropped in June. China's economy grew a record 18.3% in the first quarter of 2021 compared with the same quarter last year.

The People's Bank of China (PBoC) has kept its benchmark lending rate unchanged. The central bank said in June it plans to make policy more targeted and flexible while keeping the economy's leverage ratio stable. PBoC Governor Yi Gang said consumer inflation will likely stay below the government's target this year and monetary policy must remain stable. Chinese bonds continue to attract international investors. The 10-year government bonds yielded around 3.075% compared with about 1.308% for the 10-year U.S. Treasury. In recent weeks, the central bank has tried to slow the yuan's appreciation against the dollar and increase its flexibility.

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Global financial markets were mixed during the second quarter.