2021 Mid-Year Outlook: Fixed Income

The bond market has become surprisingly quiet in the past few months. Ten-year Treasury yields have settled into a narrow range near 1.6%, after peaking at 1.74% on March 31st, a steep rise from less than 1% at the start of the year. The market has shrugged off wide swings in the economic data, a spike in inflation readings, and uncertainty about the direction of fiscal and monetary policies. It reminds us of one of the puzzles in children’s magazines where you’re supposed to figure out “what’s wrong with this picture?”

Ten-year Treasury yields have been rangebound

Source: Bloomberg. US Generic Govt 10 Year Yield (USGG10YR Index). Daily data as of 6/1/2021. Past performance is no guarantee of future results.

In our view, what’s wrong is that bond yields at current levels aren’t consistent with the likelihood of continued strong economic growth, and the risk of higher inflation. Even if economic growth and inflation revert to pre-pandemic levels over the next year—an outcome we see as unlikely—yields still appear low and offer little room for error. Considering the unprecedented fiscal stimulus in place to boost economic growth and the Federal Reserve’s willingness to tolerate higher inflation, we see room for bond yields to move up in the second half of the year. Short-term interest rates should remain anchored near zero by Fed policy, but we expect 10-year Treasury yields to rise to the 2.0% to 2.5% level.

Fiscal stimulus to support demand

The unprecedented size of the fiscal stimulus response to the COVID-19 crisis is a major reason behind our expectation for higher bond yields. Thanks to the forceful fiscal and monetary response since the onset of the COVID-19 crisis, the economy has already recovered the output that was lost during the pandemic in nominal-dollar terms. There are still significant gaps in employment and in some sectors of the economy, but with more fiscal stimulus on the horizon, gross domestic product (GDP) growth is poised to move above the long-term trend this year, and will likely stay above it through at least 2022.

Nominal GDP is above its pre-pandemic level

Nominal GDP from 2007 to 2021. Most recent nominal GDP shown is more than 22 trillion dollars.

Source: U.S. Bureau of Economic Analysis, Gross Domestic Product (GDP). Quarterly data as of Q1-2021.

Consensus estimates call for real GDP to expand at a 6.5% pace this year and 4.0% next year—well above the 2.3% average rate that prevailed for the decade prior to the pandemic (Q3 2010 through Q4 2019). The risk is that strong demand growth relative to supply will lead to higher prices for longer than expected and inflation pressures will become embedded.

While we agree with the Fed that the recent sharp jump in inflation due to supply chain shortages and a sharp rebound in consumer spending is likely transitory, it may not recede as quickly. With more fiscal stimulus coming up that could fuel already-strong growth, there is a risk that inflation pressures persist for the rest of this year and into 2022.

Year-over-year inflation surged in March, when compared to last year’s sharp drop

With few exceptions, over the past 21 years inflation has been below 2% until surging in April 2021 to 3.1%.

Source: Bloomberg. U.S. Personal Consumption Expenditure Core Price Index (PCE CYOY Index). Monthly data as of 4/30/2021.

The Fed is making a policy choice to wait for higher inflation

In fact, the Federal Reserve is making a policy choice to tolerate higher inflation in hopes of boosting employment. Having missed its inflation target for most of the past decade after the financial crisis, the Fed’s inflation tolerance is higher. It has adopted an “average inflation targeting” policy, which means the Fed doesn’t intend to tighten policy pre-emptively. Inflation can overshoot its 2% target for the Fed’s benchmark index, core personal consumption expenditures (PCE), for an extended time period to make up for undershooting it for many years.

Inflation is already above 2% based on most measures of inflation that the Fed watches

Inflation based on these 8 measures, ranging from 2.1% FRBC Median CPI to 4.2% Overall CPI.

Source: Bloomberg. Bloomberg. Indexes shown are: Consumer Price Index for All Urban Consumers: All Items (Overall CPI), U.S. Personal Consumption Expenditure Core Price Index (Core PCE), U.S. Personal Consumption Expenditure Deflator (PCE Deflator), Consumer Price Index for All Urban Consumers: All Items Less Food and Energy (Core CPI), 16% Trimmed-Mean Consumer Price Index % change at annual rate (16%Trimmed-Mean Consumer Price Index), Sticky Price Consumer Price Index (FRBA Sticky Price CPI), Median Consumer Price Index % change at annual rate (FRBC Median CPI), Sticky Price Consumer Price Index, Less Food and Energy (FRBA Sticky Price CPI Core). Monthly data as of 4/30/2021.

While we don’t expect the Fed to allow inflation to reach the high levels of the 1970s, we do see the potential for an inflation rate fluctuating between 2% and 3% over the next few years, which is significantly higher than what we’ve experienced in recent years and well above the yield currently offered on 10-year Treasury bonds.

Inflation expectations are elevated. Market-based and survey-based readings of inflation expectations indicate that consumers are looking for higher levels over the longer term.

Markets expect higher inflation in five and 10 years

The breakeven inflation rate five-year expectations is 2.6% and the 10-year expectations is 2.45%. Data spans May 2020 to May 2021.

Note: Breakeven inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.

Source: Bloomberg. U.S. Breakeven 10 Year (USGGBE10 Index) and U.S. Breakeven 5 Year (USGGBE05 Index). Daily data as of 5/28/2021.

Real yields are negative

Our biggest concern is about negative real bond yields—that is, yields adjusted for inflation expectations. Nominal 10-year Treasury yields, at 1.6%, are far below market expectations for average inflation of about 2.5% during a 10-year time horizon. Meanwhile, the real yield for 10-year Treasury Inflation-Protected Securities (TIPS) is negative, reflecting investors’ low expectations of rising rates.

The 10-year TIPS real yield is negative

Comparing the 10-year Treasury yield with the 10-year TIPS real yield from June 2010 to June 2021, the Treasury yield is 1.61% and the TIPS real yield is -0.87%.

Source: Bloomberg. Generic US 10 year Treasury yield (USGG10YR Index) and US Generic Govt TII 10 Yr (USGGT10Y INDEX). Daily data as of 6/1/2021. Past performance is no guarantee of future results.

Negative real yields are an outgrowth of depressed economic activity globally and central bank policies. The Federal Reserve and Bank of Japan have set their base policy rates near zero, while in Europe the rate is negative. When combined with bond-buying programs, the central banks have anchored nominal interest rates at low levels. However, as the economy improves and the Fed shifts away from its extraordinary policies, real yields are likely to rise.

The last time real yields were this steeply negative was in the spring of 2013, just before then-Federal Reserve Chair Ben Bernanke made a comment about the Fed’s plans to begin reducing its bond-buying program, sending nominal and real yields sharply higher.

We are not expecting a repeat of the 2013 “taper tantrum.” So far, the market has responded calmly to recent comments from Fed officials indicating that they are considering reducing the pace of its bond buying starting later in the year. However, in a healthy, growing economy, yields adjusted for inflation expectations should be positive. Once the economy is on a sustainably stronger path and central banks pull back on extraordinary policies, there is ample room for nominal yields to rise.

After the financial crisis, real 10-year Treasury yields averaged about 0.5% for several years. Since this recovery is moving much more rapidly and is supported by far more expansive fiscal policy, real rates should recover to at least that level. We doubt that inflation expectations will ease much given the prospects for fiscal stimulus and the Fed’s inflation stance, so that suggests nominal yields are likely to adjust higher.

Outlook for Federal Reserve policy

Of course, a lot depends on policies pursued by the Federal Reserve. For now, the Fed has been clear that it is putting its employment mandate ahead of its inflation mandate, which means it likely will be at least a year or two before a hike in interest rates. However, we do expect the Fed to begin pulling back on its large bond purchases this year, which is the first step toward normalizing policy. An announcement could come later this summer.

The Fed will likely begin to “taper” its bond purchases beginning in the fall from the current pace of $120 billion per month. Given the large amount of monthly purchases, a reduction of $10 billion per month in Treasury purchases and $5 billion per month in purchases of mortgage-backed securities (MBS) appears reasonable. At that pace, it would take about eight months for asset purchases to end. At that point, in late 2022 or 2023, the Fed can consider raising short-term interest rates if the economic outlook warrants it.

The Fed's bond holdings are now more than $7 trillion

Fed's bond holdings are Treasuries, MBS and Agencies, TIPS, T-bills, and Floating-Rate Notes. In May 2009, the holdings totaled around $1trillion; in May 2021, with a sharp rise in 2020, holdings are over $7 trillion.

Source: Bloomberg, using weekly data as of 5/26/2021. FED System Open Market Account Floating Rate Notes held in the Account (SOMHFRNS Index), FED System Open Market Account T-bills held in the Account (SOMHBILL Index), FED System Open Market Account Federal Agency Securities held in the Account (SOMHAGCY Index), FED System Open Market Account Agency MBS held in the Account (SOMHAMBS Index), FED System Open Market Account T-notes & Bonds held in Account (SOMHBOND Index), FED System Open Market Account TIPS held in the Account (SOMHTIPS Index).

It’s worth noting that the bond market likely will anticipate these events by sending yields higher in advance of the shift in Fed policy. The only previous comparable time period was the post-financial crisis time from 2010 to 2016. The Fed engaged in three rounds of bond buying (quantitative easing, or QE) and one period of actual tapering. Each time, yields rose during the QE time period and fell when QE ended, or tapering began. Consequently, we believe investors should be prepared for bond yields to rise in the lead-up to a change in Fed policy.

The 10-year Treasury yield declined after the Fed ended each of its QE programs

10-year Treasury yields rose, then fell after each of the four QE3 taper announcements between 2008 and 2021.

Source: Bloomberg, using weekly data as of 5/28/2021. US Generic Govt 10 Yr (USGG10YR Index). Shaded areas represent the periods of Quantitative Easing. Past performance is no guarantee of future results.

Risks to our view

It’s possible that the re-opening of the economy will be slower than we expect or that inflation pressures will ease back to pre-pandemic levels sooner rather than later. While we believe this is a low probability, the coronavirus is still spreading in a number of countries where vaccination levels are low, and this could hold back global growth. In that case, nominal and real yields would likely remain low and the Fed would have difficulty exiting its very easy policy setting. With yields already very low in other major developed markets, U.S. bond yields are attractive on a relative basis, drawing in foreign investors.

From a longer-term perspective, there are structural forces that could keep yields lower for longer. The demographic trends of aging populations globally and high government debt loads could limit potential growth and keep interest rates low. We believe these will be factors that limit how high yields will go longer term, but shouldn’t prevent a move up to 2.0% to 2.5% in 10-year Treasuries this year.

What investors can do

Due to our expectations for higher bond yields in the second half of the year, we continue to suggest investors keep the average duration in their portfolios below their normal benchmark. For example, for an investor with a portfolio of core bonds that is similar to the Bloomberg Barclays U.S. Aggregate Bond Index, which has an average duration of 6.5 years, we would suggest reducing it to the three- to five-year region. If yields do move higher, with real yields in positive territory, we would view it as an opportunity to gradually extend duration through a laddered approach.

On the positive side, expansive fiscal policy and improving economic growth are supportive to the credit quality of corporate and municipal bonds for core bond holdings.

For investors willing to take more risk, higher-coupon bonds with lower durations, such as high-yield and emerging-market bonds, can provide higher returns, although we would still limit allocations to no more than 20% of an overall portfolio.

Yield compensation versus interest rate risk

Chart shows yield to worst/duration. Global at 0.11%, Munis at 0.21%, Core Bonds at 0.25%, Investment Grade Credit at 0.26%, USD Emerging Market Bonds at 0.58% and High Yield Credit at 1.10%

Source: Bloomberg, as of 5/20/2021. Indexes used: Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade Credit), Bloomberg Barclays U.S. Aggregate Bond Index (Core Bonds), Bloomberg Barclays Global Aggregate ex-US Index (Global x-usd), Bloomberg Barclays EM USD Aggregate Index (USD Emerging Market Bonds), Bloomberg Barclays U.S. Corporate High Yield Bond Index (High Yield Credit) and the Bloomberg Barclays Municipal Bond Index (Munis). Yield-to-worst is the lower of the yield-to-call or the yield-to-maturity, and duration is a measure of interest rate sensitivity; the higher the duration, the more sensitive an investment is to fluctuating yields. The yield-to-worst/duration is meant to illustrate how much yield an index offers relative to its average duration, and is measured as a point in time, as of 5/20/2021, and can vary depending on the yield and duration of a security at the time of the investment.

Overall, our view is that the recent calm in the bond market doesn’t fit the picture of the economic and inflation risks we see for the second half of the year. We see the recent plateau in yields as a pause before the next wave higher.