Interest rates moved off their historically low levels to start the year, but we believe they can still go higher. Higher inflation expectations, the strong economic recovery, less involvement in the bond market from the Federal Reserve, and a record amount of Treasury issuance this year are all reasons why we believe interest rates can move higher. Our target for the 10-year Treasury Yield at the end of 2021 is between 1.75% and 2.0%.

The case for still higher yields

Inflationary pressures are building as the economy continues to recover. As a bondholder’s main nemesis, inflation erodes the real value of principal and interest payments, making them worth less. While we don’t believe inflation will be a lasting problem, we do expect to see higher consumer prices in the near future. This should nudge interest rates higher throughout the rest of this year.

We’re also keeping a close eye on copper prices. The ratio of copper prices to gold prices has been an important predictor of where the yield of the 10-year Treasury Yield could be [Figure 9]. Copper is an important input price for a number of products, as copper prices increased due to the strengthening of the global economy, 10-year Treasury Yields haven’t quite kept up. While not a perfect predictor, the copper-to-gold ratio has been a reliable one and suggests interest rates can still move higher from current levels.

Stalling out

Rising Treasury yields have been a headwind to core fixed income returns this year, with the first quarter being one of the worst quarters ever for bond returns. Generally speaking, the yield spread between Treasury securities and non-Treasury bond securities can help cushion losses when interest rates move higher and bond prices fall. However, with valuations within most fixed income sectors already at lofty levels, there hasn’t been enough spread to offset rising Treasury yields. This has caused the prices of many bond sectors to fall as interest rates have moved higher. Unfortunately, we expect higher interest rate trends to continue, albeit at a much slower pace than we’ve experienced so far this year. This will add further downward pressure on core fixed income returns.

Returns for core fixed income – as defined by the Bloomberg Barclays U.S. Aggregate Bond Index – through the remainder of the year are expected to range from low to negative in certain scenarios [Figure 10]. Because we believe interest rates will move higher from current levels, core fixed income returns may add more negative returns to the already negative year-to-date returns. If core fixed income returns are negative for the year, it’ll be the first time since 2013, which was a great year for stocks. It was also the last time the Fed started talking about tapering its bond buying programs.

Fixed income through year-end

We still recommend investors reduce the interest-rate sensitivity in their portfolios. Mortgage-backed securities (MBS) do not offer the upside of corporate bonds, but can be more resilient in a rising-rate environment. Investment-grade corporates tend to be more rate-sensitive than MBS.

Their credit sensitivity may make them more vulnerable than MBS if stocks pull back. However, we still think the short-to-intermediate part of the corporate credit universe makes sense. Remember, longer-term bonds are impacted more by higher rates. This is why we recommend an underweight to Treasuries.

For suitable income-oriented investors, adding more credit-sensitive sectors like bank loans and emerging market debt to their portfolios may help compensate for the reduced income potential of a low-rate environment. However,  we’d still recommend high-quality bonds comprise the bulk of any bond allocation.

Use bonds as your safety belt

If we’re expecting higher Treasury yields and low-to negative returns for core fixed income, why would anyone want to own bonds? Frankly, in case something bad happens to cause equity markets to sell off. Simply put, bonds help you stay in stocks and make progress toward your long-term goal. Core bonds, and more specifically Treasury securities, continue to be the best diversifier during equity market declines.

As we look at how Treasury securities have performed during periods when the S&P 500 Index dropped 3% or more, we see Treasury security returns have been mostly positive [Figure 11]. When you consider stocks are in the second year of a bull market that’s historically brought increased volatility, core fixed income can help dampen and potentially offset some of those losses. While we still like stocks over bonds over the course of the year, we do think high-quality fixed income continues to serve a purpose in portfolios.

All eyes on the fed’s road ahead

When we evaluate the economic and financial landscapes, the Fed is a key risk we’re keeping our eyes on. Since March 2020, the Fed’s supported the economy and financial markets by purchasing $80 billion in Treasuries and $40 billion in mortgage securities, and keeping short-term interest rates near zero. As the economy continues to recover, however, the need for continued monetary support wanes.

While we still think it’s too early for the Fed to begin to increase short-term interest rates, we do think the discussion around reducing the size and scope of bond purchases – also known as tapering – will start to take place soon. How the market will react to these discussions is unclear at this point, and there’s a risk that a communication error by the Fed could cause interest rates to move higher.

 

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