Interest rates have been rising since August 2020, with the yield on the 10-year US Treasury bond having drifted 100 basis points (bps)1 higher over the past six months or so. But recent rate action has really caught the market’s attention, particularly the 10-year’s swift 30-basis point yield increase and the spillover into global equity markets.
Is this latest bout of “rate repricing” due to higher inflation expectations? Stronger economic growth? Treasury supply concerns? Investors “fighting the Federal Reserve (Fed)”? Or is it those pesky convexity2 hedgers? Let’s take a stab at making sense of it all.
Yields have risen for the right reasons – Rates have been adjusting to prospects for better growth and higher inflation for months now, reflecting an improving pandemic outlook and ample policy support. Rising inflation expectations are baked into wider spreads3 between Treasury yields and real (inflation-adjusted) yields, using 10-year Treasury Inflation-Protected Securities (TIPs)4 as a proxy. Orderly rate moves have historically been absorbed by risk markets, with equities climbing higher and credit spreads narrowing.
The recent rise in rates was different – With the latest spike in yields, real yields are rising not on expectations of increasing inflation but rather on the expectation that the Fed could hike its policy rate sooner than previously thought. FIGURE 1 shows an unusual inversion of the “breakeven” inflation curve, reflecting higher near-term inflation expectations relative to longer-term expectations that formed in February 2021. This is a concern because higher real yields could
snuff out the economic recovery, whereas higher inflation expectations lower real yields.
The Fed’s playbook hasn’t changed – Even though the market has been “fighting the Fed” (i.e., challenging it to meet growing expectations of a sooner-than-anticipated rate hike), Fed Chairman Jerome Powell and other Fed officials reiterated that: 1) rate hikes will not be considered until there has been “substantial further improvement” in the economy; and 2) structural issues such as automation, globalization, and demographics have likely suppressed long-term inflation.
Brace for more “Fed fights” – There could be further yield increases going forward. With economies reopening, higher commodity prices, depressed inventories, supply-chain disruptions, and pockets of skilled-labor shortages, inflation scares could periodically roil the markets. Given that so many risk assets5 have fed off of the prevailing low-rate/high-liquidity regime, I think there are bound to be some drawdowns that cannot withstand higher rates.
10-year yields could go higher – I believe markets could continue to remain on “inflation watch,” which may induce greater rate volatility and higher 10-year yields. If real GDP is 3% and inflation is 2%, and the Fed’s asset purchases are worth -100 to -200bps, a 10-year yield of 2% to 3% is imaginable over the next six to 12 months. However, I think the Fed knows this and views it as a healthy mechanism for resetting growth and inflation expectations to more normal levels, while also wringing out some of the excess in asset prices. The Fed will probably continue to telegraph its rate-hike plans and could even extend its asset-purchase programs to help manage long-end rates lower.
Near-Term Inflation Expectations Have Moved Higher
Source: US Treasury, as of 2/25/21.
For total return, favor short duration. For total-return-seeking bond investors, I suggest limiting duration6 exposure, as 10-year yields could rise further still in the months ahead.
Higher rates could impact equities. With US large-cap growth looking more vulnerable to rising rates, I continue to favor value-oriented, non-US equities; cyclical sectors (e.g., financials, industrials); and smaller caps.
“Bad” inflation headlines could spook markets again. The market could continue to react to recurring inflation headlines by pushing yields higher, which could be temporarily disruptive to risk assets.
Higher yields may come with an improving economy. Higher yields can bring about a healthy asset-repricing process. While the path may be bumpy at times, I believe today’s environment could remain conducive to owning risk assets.
The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views, and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.
1 A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security.
2 Convexity is a measure of the curvature, or the degree of the curve, in the relationship between bond prices and bond yields.
3 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.
4 Treasury Inflation-Protected Securities (TIPS) are Treasury bonds that are adjusted to eliminate the effects of inflation on interest and principal payments, as measured by the Consumer Price Index (CPI).
5 Risk assets (such as equities, commodities, high-yield bonds, real estate, and currencies) have a significant degree of price volatility.
6 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.
Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • US Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest. • The value of inflation-protected securities (IPS) generally fluctuates with changes in real interest rates, and the market for IPS may be less developed or liquid, and more volatile, than other securities markets. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. • Small-cap securities can have greater risks, including liquidity risk, and volatility than large-cap securities. • Investments focused in specific sectors may be subject to increased volatility and risk of loss if adverse developments occur. • Different investment styles may go in and out of favor, which may cause an investment to underperform the broader stock market.