Rotation toward higher rates
The economic rotation into reopening activity, when combined with continued massive stimulus packages, has re-ignited fears of possible inflation overshoots. Consequently, interest rates moved sharply higher during the quarter. The 10-year treasury note rose nearly 70 basis points to finish at 1.74%—back to pre-COVID-19 levels. This sharp rise sent returns firmly into negative territory for the year-to-date.
Despite inflation concerns and the upward shift in rates, the Federal Reserve continues to pledge that short-term rates will be on hold until at least late 2023. Treasury yield curves are indicating that the Fed will be moving rates higher next year, so we’ve rotated into a situation where the bond market is at odds with Fed guidance.
Additional Federal stimulus was approved during the quarter, pushing total stimulus to the $5 trillion range (thus far). With the jobs market healing, incomes steady and growing, COVID-19 vaccines rolling out aggressively, a massive wall of excess savings and more stimulus dollars ready to be unleashed, it is quite rational to assume that demand is likely to increase dramatically during the second half of the year. Given that there are several million Americans who have yet to be drawn back into the workforce (perhaps because they have stimulus dollars to pay the bills), it is likely that our ability to produce goods and services will not ramp up as quickly as demand increases. This sets the stage for broad-based inflation as we move into 2022. We’re already seeing pockets of serious inflation in some parts of the economy— such as lumber, commodities, real estate. Broad inflation will only occur once wages begin to push higher, causing a sustainable spike in overhead costs.
We do not believe that inflation will become a serious issue this year. We do believe that it has a high likelihood of becoming a hot spot as 2022 unfolds, and that the Fed is likely to start reducing its asset purchase program (a form of tightening) and increase overnight rates earlier than they are currently projecting. We also think that the risk to the inflation outlook is most likely to the upside, so we may be dealing with higher inflation and a Fed that is forced to dramatically revise their forecasts within the next 12-18 months.
High-yield followed the equities markets, capturing strong positive returns as the vaccines began broad distribution and the economy showed signs of solid recovery. High-yield spreads dropped to new cyclical lows, having fully recovered from last year’s sell-off. With the Fed and Congress promising (and delivering) massive ongoing monetary and fiscal stimulus, the high-yield markets succeeded in delivering strong positive returns when the rest of the bond market was hampered by rising rates. The phenomenal performance of the first quarter is not at all likely to be repeated throughout the rest of the year, but we believe the yield carry of roughly 4.00% should sustain reasonable total returns going forward.
Despite growing concerns over inflation, we believe the Fed will stand firm on its pledge to keep rates anchored near zero—at least through 2021, perhaps longer. Given the powerful upward shift in rates that already occurred during the first quarter, we believe that rates are likely to grind slowly higher going forward. This should allow fixed income to generate modest positive returns. However, this also means that the decades-long run of 5-10% total returns from bonds has likely come to a close. We are much more likely to be facing several years of returns in the 1.0% range.
This article is for informational purposes only and is not intended to be investment advice. The projections in this article are based on information as of a specific time and are subject to change. Please contact your investment advisor with any questions.
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