Tuesday, March 2, 2021
Coming into 2021, one of our higher-conviction ideas was that we would see rising long-term interest rates in the United States; it’s one of the reasons we recommended suitable investors consider an underweight to interest rate sensitive fixed income. However, we didn’t expect interest rates to move this high, this fast. The 10-Year Treasury yield started the year at 0.91% and ended the month of February at 1.41%, down from an intraday high of 1.61%. As such, core fixed income assets are off to one of their worst starts ever (remember that as yields go up, prices go down).
“Core fixed income assets aren’t off to a very good start this year, but we don’t think investors should abandon high-quality fixed income assets as they play an important role in a diversified portfolio” says LPL Financial Chief Market Strategist Ryan Detrick.
So what is driving interest rates higher? Changing expectations
Inflation and growth expectations are important factors into the fundamental outlook for interest rates. Broadly speaking, what we’ve seen in the bond market this year is a re-pricing of both higher inflation and higher growth expectations. Inflation expectations have steadily moved higher, and market-based gauges of inflation expectations are the highest they’ve been since 2011. We don’t expect much higher inflation expectations from here, but we are watching how additional fiscal stimulus flows into the economy. Additionally, it seems increasing economic growth expectations have picked up recently as well. An increase in growth expectations may put pressure on the Federal Reserve (Fed) to move away from its low interest rate policy sooner than expected, which has put upward pressure on longer-dated Treasury yields.
An unfortunate byproduct of those higher expectations is that we’ve seen an increase in the volatility of the 10-Year Treasury. As shown in the LPL Chart of the Day, daily percentage changes for the 10-Year Treasury yield are above historical norms (each vertical line on the chart represents the one day percentage change in the 10-Year Treasury yield). As shown, over the past several months, yields have regularly moved 10-20% in either direction on any given day. We think this is due to the changing interest rate dynamic and believe that interest rate volatility will subside the further we get into this new interest rate regime.
Not all of the sell-off is fundamentally driven though
Along with the fundamental repricing of inflation and growth expectations, two other factors are seemingly behind the most recent increase in yields. First, as interest rates have increased, hedging and de-leveraging events have caused rates to reprice to higher levels. While these are natural occurrences in rising rate environments, they do add to the increased volatility we’ve seen lately. We believe that the worst of these events is likely behind us. Second, we’ve expected the Fed to keep yields from moving too high aor too fast. However, during Fed Chairman Jerome Powell’s recent testimony, he welcomed the sharp move higher as a sign of “confidence” in the economic recovery. Moreover, during last week’s Treasury Auction, selling bonds to the public to fund deficits, natural buyers of these securities largely balked at the offering, and in order to sell the offering in its entirety, the Treasury had to increase yields to make them more attractive. It seems that the market is challenging the Fed’s resolve to keep interest rates at current levels. If the natural buyers of Treasury securities continue to stand on the sideline or the Fed doesn’t take a harder stance on rising rates, we could see yields drift higher from here.
What do we expect from here?
Our baseline expectations for interest rates are still higher from here. Coming into the year, our end-of-year forecast range for the 10-Year Treasury yield was 1.25% – 1.75%, and we still think 1.75% is a realistic high-end range. The Treasury market has moved sharply higher from its lows back in August, so we expect rates to remain range bound in the near term, but they may move higher in the coming months. We will continue to evaluate our year-end forecast and update our recommendations when we believe adjustments are warranted. As a reminder, although core fixed income assets are off to their worst start ever, the Bloomberg Barclays U.S. Aggregate Bond index is only down 2.15% on a year-to-date basis (ended Feb 26). So, we don’t believe investors should abandon high-quality fixed income assets altogether just because long-term rates could remain in an upward trend during 2021.
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