Fixed income markets: three things we’re watching

Key takeaways

• We continue to believe the Fed will be patient and incremental, with changes to the policy rate coming much further down the road.
• The very low global yield environment is a favorable tailwind for many fixed income asset classes.
• Active managers are well-positioned to select the sectors, industries and individual securities offering relative value in all kinds of markets.

As the U.S. economy recovers from the COVID-19 pandemic, investors are assessing the changing fixed income landscape. While much of the uncertainty has eased, we await the next turn of the markets. In the meantime, we are carefully monitoring three elements: inflation, Fed policy and global yields. Together these factors should result in only modestly increased rates over the balance of the year. In this environment, a broad range of credit sectors may continue to perform, and active management makes a difference.

Transitory factors are causing inflation to rise

Talk of inflation has consumed recent headlines, especially as it hit 5.4% year-over-year in June. However, this notable increase is largely due to a combination of base effects and supply bottlenecks as the economy reopens. These factors should diminish over time.

Base effect. The base effect increases the inflation rate because the year-over-year data is measured relative to last spring and summer’s extremely low rates, when much of the economy was shut down at the beginning of the pandemic. However, this impact mathematically declines over time, regardless of whether the inflation rate continues at its recent strong rate of 0.4% per month or declines to the more modest 0.14% historical average rate. Supply line bottlenecks have created pricing pressures in some industries, but these issues should resolve as manufacturing production resumes over the next few months.

Wage growth. We’ve seen some evidence of wages creeping up. However, the labor market remains far weaker than in early 2020, and the pace of improvement has disappointed. The unemployment rate remained elevated at 5.8% in May, and the total number of jobs is not anticipated to reach pre-pandemic trend levels for two years or more, making spiraling wage growth less likely. In addition, we have yet to see the labor market’s response to the end of more generous pandemic unemployment benefits and fully reopened schools in the fall. For these reasons, we think uncontrolled inflation remains unlikely.

Expectations. Inflation expectations drive interest rates, especially longer-term. But the overall effect of inflation on rates may be muted this cycle. The Fed is now letting inflation overshoot its 2% target for a period of time after a period of undershooting. This makes the Fed less likely to hike rates in the face of rising inflation, especially when the Fed considers inflation temporary and can keep real rates from increasing sharply.

Disinflationary forces. We think longer-term forces such as demographics and globalization will cause inflation to naturally revert toward 2%. The aging of the population reduces demand for goods, and lower new household formation reduces overall consumption. At the same time, globalization allows us to import lower-priced goods and services, keeping costs down. Of course, if inflation were to rise in a disorderly fashion, it would likely cause rates to rise faster and could impair fixed income returns.

Fed policy should slowly respond

We are closely watching the Fed’s policy responses to the reopening economy, improving employment and inflation. While the market can increase intermediate- to long-term rates in anticipation of Fed action, shorter-term rates remain anchored by the fed funds rate.

We continue to believe the Fed will be patient and incremental, with changes to the policy rate coming much further down the road. We expect Fed policy will progress through three phases:

1. Waiting patiently: likely to continue for most of 2021

The Fed keeps the fed funds rate at 0% to 0.25% and continues purchasing $120 billion per month of U.S. Treasuries and mortgage-backed securities, even in the face of temporarily higher inflation, to work toward maximum employment.

The Fed is unlikely to reduce accommodation without further progress on the unemployment rate and broader labor market metrics. Signaling about tapering will likely come around September, and we expect market rates to increase at that time. The actual tapering announcement is not expected to come until fourth quarter. However, we anticipate the tapering to be well-telegraphed to prevent another volatile 2013 taper tantrum-style selloff.

2. Tapering steadily: likely to begin at end of 2021 or early 2022

Following a defined signaling, the Fed slows its asset purchases. During this period, the fed funds rate remains at 0% - 0.25%, anchoring the short end of the yield curve. Asset purchases decline in a scheduled fashion over time. The market will likely have already priced in much of the policy change before it occurs, reducing the effect of the actual tapering on intermediate- to long-term rates.

3. Hiking slowly: likely in late 2022 to early 2023

The Fed begins to gradually raise short-term interest rates, ending at a relatively low terminal level. Movement will be contingent on achieving sufficient progress toward maximum employment and price stability, within the context of its flexible average inflation targeting framework. We would expect the market to follow the same data. While short rates will not increase until the actual rate hike, intermediate to longer-term rates likely have less capacity to rise from here.

What does this mean for fixed income markets? Policy changes should be incremental, anticipated and well-signaled, so a slow increase in interest rates over time is more likely than a sharp move. In this environment, fixed income asset classes, especially higher yielding sectors, may produce positive returns. Their income return may overcome the negative price impact of a slow increase in rates over time.

Low global yields support higher yielding assets

The very low global yield environment is a favorable tailwind for many fixed income asset classes. Unlike inflation, we expect these low yields to persist. Beyond the Fed, global central banks will remain focused on supporting their economies and financial markets. Many countries may maintain their stimulus policies to keep their rates contained as the pandemic continues to severely impact non‑U.S. economies and will likely remain unchecked for longer due to vaccine scarcity.

These very low global rates, including $15 trillion in outstanding worldwide negative-yielding debt, and cheap currency hedging costs help keep U.S. rates low by inspiring purchases of higher yielding, U.S. assets. Even the highest-quality U.S. Treasuries offer yields well above those available from other developed market governments, including those deemed riskier, like Italy. In addition, the U.S. bond market remains the world’s largest and most liquid, as well as a safe haven during turbulent times.

Credit sectors offer income advantages

Beyond governments, a wide range of fixed income sectors may provide even more attractive yields. Their significant income advantage helps maintain demand, which supports prices over time — even as rates rise modestly. In addition, some sectors, such as floating-rate senior loans and non fixed coupon rate preferred securities, may benefit from rising rates since their coupons increase with market rates. And, their income advantage helps offset any price declines due to modestly rising rates.

Broadly diversified, actively managed strategies may uncover opportunities

With their deep research capabilities, active managers are well-positioned to select the sectors, industries and individual securities offering relative value in all kinds of markets. Portfolios that include both investment grade and below investment grade sectors access the widest set of opportunities. Consider these types of portfolios as economic conditions evolve and rates modestly rise:

Short-term bond. Typically combine higher quality, short-duration sectors, like U.S Treasuries, asset-backed securities and mortgage-backed securities, with smaller amounts of higher-yielding sectors, such as high yield corporates and emerging market debt. Diversified short-term bond funds can reduce overall interest rate sensitivity while still benefiting from a wide array of sectors.

Core plus. Combine a larger portion of higher-quality sectors — like U.S. Treasuries, mortgage-backed securities and investment grade corporates — with smaller (typically up to 30%) allocations to lower-quality sectors, such as high yield corporates, senior loans and emerging markets debt. The ability to actively adjust allocations to lower-quality segments can increase yield while balancing overall risk.

Multisector bond. Augment a base of diversified higher-quality sectors with larger allocations (typically up to 50%) to below investment grade securities. Offer more yield potential than core plus, in return for greater potential volatility.

Core/core impact with limited plus sector exposure. Focus more on higher-quality sectors to maintain return profiles similar to the broad bond market and a low correlation to equities. Core strategies with the flexibility to add small amounts (0% to 10%) of lower-quality sectors can be particularly attractive in this low yield environment. Core strategies with an impact investing mandate add the additional diversification of responsible investing themes.

Outlook

Healthy growth continues to support credit sectors

The economic recovery continued to accelerate in the second quarter. Gains in Europe and Latin America, which had been lagging, balanced moderation in U.S. and Asian growth. Based on the strong data already received, U.S. output likely rose at an annualized pace of roughly 10% for the quarter, and the eurozone and China should each grow about 6% annualized. Consumers have strong balance sheets and are spending more money, while the labor market continues to heal, supporting incomes. Further increases in business investment have more than compensated for a slowdown in the housing sector.

We think global growth will continue to pick up and will probably eclipse 6% for the full year, which would be the fastest pace on record going back to 1960. As COVID-19 vaccination rates continue to improve globally, economic activity should normalize further. We anticipate the U.S. and global economies will grow strongly in the second half of 2021, with the labor market set to fully normalize by next year. Inflation has been running high in recent months, but we believe the peak in the rate of price increases is already behind us, and headline inflation should moderate moving forward.

On the fiscal front, we still expect passage of a sizable infrastructure package this year. It will likely total around $2.5 to $3.0 trillion over the next decade, with new revenues financing roughly half of that amount. Since its scale is dwarfed by previously enacted COVID 19-response spending, it would merely moderate the headwind of fading fiscal stimulus rather than provide another boost. In terms of monetary policy, the Fed remains likely to make a tapering announcement in the fourth quarter, with reduced asset purchases beginning at the end of 2021.

We believe the backdrop of healthy growth and the gradual removal of policy accommodation should support spread assets. Earnings growth will likely be robust this year, while defaults are set to fall to low single-digit rates, benefiting corporate credit. Although we expect rates to increase from current levels, we do not anticipate another “taper tantrum” bout of volatility. Instead, we anticipate measured and orderly increases to match the improved economic outlook.