July 2021
2nd Quarter 2021 Fixed Income Review
• Q2 fixed income markets experienced positive performance although Treasuries and high credit quality were still negative year-to-date
• Although a strong influence during the first half of 2021, the reflation trade in fixed income suffered following the June FOMC meeting
• U.S. Treasury yield “real” rates are still negative across the entire yield curve when taking the current rate of inflation into account
• Despite the recent rally in longer dated maturities U.S. Treasury rates continue to be among the highest in the developed world
Following one of the worst quarters for bond markets in decades, fixed income markets experienced positive performance in the 2nd quarter of 2021 as U.S. equity markets hit all-time highs amid improving global growth and higher inflation expectations. Additionally, world central banks, including the U.S. Federal Reserve, signaled a continuation of highly accommodative monetary policies. However, investment grade and U.S. Treasury index returns were negative year-to-date through the end of Q2 (see graph below).
Below are 2nd quarter and year-to-date Bloomberg Barclays fixed income index returns:
The 10-year U.S. Treasury (UST) note, a bell-weather measure used in the fixed income markets, ended Q2 2021 with a yield of 1.47%, an unexpected decrease from 1.74% at the end of Q1 2021. The 2-10-year UST yield spread, an often-cited measure of the slope of the yield curve, ended Q2 2021 at 122 basis points. That same yield spread has averaged around 60 basis points for the past five years.
The chart below shows the changes in the UST yield curve from Q2 2020 (gold line) and the end of Q2 2021 (green line). The bar graph at the bottom shows the changes in yields for select maturities.
In their most recent meeting in June, the FOMC left interest rates unchanged and signaled that they would continue emergency asset purchases ($80 billion in Treasurys and $40 billion in mortgage-backed bonds per month) until the economy reaches full employment and with inflation being allowed to rise above 2%. Notably, however, the FOMC has begun to discuss the timing of a “taper” of ongoing direct asset purchases. In the Fed’s statement following the meeting, they acknowledged that “amid this progress (vaccinations) and strong policy support, indicators of economic activity and employment have strengthened.” In updated projections, 13 of 18 Federal Reserve officials expect to lift short-term interest rates by the end of 2023, up from 7 who expected that in March, a marked shift.
Additionally, the FOMC updated predictions for GDP, inflation, and unemployment. Interestingly, the Fed’s median estimate for the core Personal Consumption Expenditures (PCE) Index, the central bank’s preferred measure of inflation, is expected to be 3.0% for 2021 (placing the entire U.S. Treasury yield curve in a negative real rate scenario). The median estimate for GDP in 2021 rose to 7.0% from 6.5% at their March meeting. The unemployment rate is expected to be 4.5% in 2021, a decrease from 5.9% at the previous meeting.
The bond market’s inflation expectation over the next decade has recently increased to over 2% for the first time since 2018. With portions of the fixed income and equity markets rebounding, in some cases surpassing their pre-COVID-19 highs, it is clear the financial markets continue to factor-in the beneficial effects of an extremely accommodating Fed.
Foreign sovereign bond yields generally increased during Q2 2021. Globally, negative yielding debt outstanding continued to dissipate from over $18 trillion in December 2020 to around $13 trillion at the end of the quarter.
The U.S. fixed income markets have yet to experience the overtly negative yields seen in Europe and Japan. Most domestic resources, including the Federal Reserve, do not expect negative nominal rates in the U.S. We continue to believe the use of negative interest rates is an extraordinary monetary tool being implemented by some central banks with untested results and unknown long-term repercussions.
Below, in blue, are 10-year bond yields from several foreign countries (sorted from low to high), as of 6/30/21. Noteworthy is the wide difference between the yield of the bellwether German Bund (the German ten-year note) at -0.21% compared to the U.S. ten-year note at 1.46%. There are numerous factors affecting such a wide disparity in yields between developed economies although differing economic outlooks and divergent central bank actions are essentially the cause.
The Federal Reserve has indicated it will continue with direct purchases of Treasuries and mortgage bonds in the open market in an ongoing effort to maintain artificially low interest rates, although many resources anticipate an end to direct purchases later this year, or early in 2022. Despite massive amounts of fiscal stimulus from Washington and ensuing record Treasury issuance required to finance these programs, U.S. Treasury markets ended the second quarter with unexpected buying in longer maturities (lower yields).
Several factors have been cited for the rally in longer dated Treasuries at quarter-end. Leading the list is a resurgence in COVID-19 cases worldwide as a new “delta strain” threatens a nascent recovery in many countries. Second, perhaps short-lived, traders appear to have been quick to embrace the FOMC viewpoint that transitory inflation pressures in numerous segments of the U.S. economy will likely pass as supply chains and labor markets begin to normalize later this year. Added to reasons for support were heightened foreign buying (note the previous chart) and large numbers of traders reportedly unwinding bets on higher rates following the recent Fed meeting.
The outcome of the reflationary trade has yet to be determined, but a return to anemic economic growth and the tame inflationary outlook that existed in the U.S. pre-COVID is currently baked into longer dated Treasury yields. In short, factoring in the current inflationary outlook, investors buying longer dated Treasuries are locking in negative returns, or “real rates,” as well as very sparse cash flows. Whether an anomaly or persistent condition, such an environment is more conducive for trading, not investing.
As mentioned in our previous quarterly review, these are very unusual times in the financial markets. Unprecedented amounts of central bank intervention with historically low (and even negative) interest rates, as well as overt political pressure for added accommodation at a time when sovereign deficits balloon to historic levels globally, is a challenging environment for a bond buyer.
For most fixed income accounts, we currently recommend a broad diversification of strategies, both conservative and more opportunistic, as a means of preserving capital, maintaining liquidity, creating cash flow, and pursuing positive risk-adjusted returns. We hope you will contact your portfolio manager, or any member of our fixed income team, to discuss our thoughts on fixed income, and to learn more about opportunities we believe are both appropriate and timely.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
For more information about the commentary found in this newsletter, please contact:
Sam Boldrick: sboldrick@argenttrust.com, Hutch Bryan: hbryan@argenttrust.com, or Oren Welborn: owelborn@argenttrust.com
July 3, 2021
