The risk/reward profile for bonds is changing
Yield curve: A line chart that plots the interest rates of bonds that have the same credit quality but different maturity terms. The slope of the line can provide some insights into future interest rate changes, economic activity and investor sentiment.
All eyes are on the yield curve as concerns about runaway inflation take hold among investors. The combination of low interest rates for short-term bonds (and ongoing policy maker support), the expectation of continued growth and recovery and the increase in inflation expectations has pushed yields of longer-term bonds higher. The thinking here is that rates will need to increase to keep inflation in check. This has resulted in a “steeper” yield curve. In fact, the yield curve has been steadily steepening throughout 2021.
What does a steeper yield curve mean and why does it matter? Put simply, it means the difference in interest rates between shorter-term bonds and longer-term bonds is increasing. Bond investors now require more compensation to hold longer-term bonds. With yields having reached all-time lows due to the preference for safety (due to the pandemic), another way to look at it is longer-term yields have increased from the extreme lows, but remain historically low.
The question now is how are the risks related to yield curve movements being perceived? The answer very much depends on which signals you’re paying attention to, and how far along the curve you’re looking.
In this article, I dig into the Fed’s recent policy announcement and some of the signs we’re watching that will impact yields in the months and years ahead.
Policy maker support will need to wind down and interest rates will increase eventually
Let’s start by looking back a few decades. Falling interest rates have been the norm for years in developed markets, starting in the 1980s and nearing zero more recently as policy makers work to counter the negative economic impact of the global COVID-19 crisis. Additionally, low rates have been accompanied by asset purchases by policymakers in the U.S., Canada, and Europe in attempts to boost market liquidity and to encourage market participants.
As the recovery continues and the U.S. Federal Reserve (Fed) maintains its accommodative monetary policy stance (it intends to do so until full employment and price stability are achieved), inflation has increased and investors are starting to wonder when policy makers will start to wind down support (increase interest rates and slow/stop asset purchases). With the recent spike in inflation expectations, some think it’s going to be sooner rather than later.
Why is this causing anxiety?
At this time, both the Bank of Canada (BoC) and the Fed have signaled their intention to wait for firm and sustainable signs of economic recovery before scaling back support. In the meantime, inflation has risen beyond the BoC’s and the Fed’s 2% inflation target, at least temporarily. Just recently, U.S. Consumer Price Index climbed 4.2% in April compared to last year (the expectation was 3.6%).
We believe the Fed will begin to raise rates when inflation is sustainably 2.0%. The Fed is no longer reacting to inflation expectations and, as stated above, near-term inflation is already above the target. At this time, the Fed views this as transitory. The Fed had changed its policy, allowing it to overshoot the inflation target for a period of time. The unknown is how far the new policy will allow inflation to overshoot before the Fed steps in with rate hikes and the tapering of support.
This uncertainty has left the market anxious about the potentially destructive combination of ongoing economic growth and continued policy support leading to runaway inflation. This has led to rising intermediate and longer-term bond yields.
Speaking of inflation, is it really running hot?
For their part, most central banks have been pushing back strongly against the narrative of runaway inflation, insisting they will only look at actual measures of inflation as opposed to reacting to the markets’ expectations. And the bond market appears to be listening – after rising based on investor anxiety, bond yields are now trending slightly downwards, having fallen after peaking at the end of April.
Most of the inflation we are witnessing is due to the base effect of prices having fallen so low last year. Furthermore, much of it can be attributed to pandemic-related shortages, imbalances and backlogs (timber for example) which should balance out eventually. Commodity prices, especially oil, are also much higher now than they were a year ago.
At the same time, weaker than expected employment numbers have likely helped push down those inflation expectations, at least in the short term.
And so far, central banks are backing up their words with actions – the European Central Bank for example recently increased its bond purchase program. The Fed also reiterated its commitment to asset purchases coming out of its April meeting. The Bank of Canada is the only central bank taking a more hawkish tone, scaling back its purchasing program, though that is in part due to our country’s overheating housing market.
As an investor, what does this mean?
These factors lead to one major reality for investors: the risk/return profile of government bonds is changing.
Fears of inflation and uncertainty about the future of economic growth has raised investors’ expectations of what kind of risk premium they expect from bonds moving forward. This is also happening as investors anticipate what the end of a long-term decline in bond yields will look like as interest rates rise.
For the time being, investor fears over the short-term seem to be easing with most expecting no changes to policy rates for at least 18-to-24 months. This will address risk fears and anchor the yield curve in the months ahead. Looking at longer-term bonds, there still a room for intermediate and long-term yields to go higher, but we see another near-term anchor for yields with an expected increase in Treasury supply related to fiscal support in the U.S.
Over the longer-term, wary investors will be looking for other signposts to determine the risk profile of bonds. One often overlooked factor that we are looking at is what’s known as the terminal rate, sometimes called a “natural” or “neutral” interest rate that aligns with full employment and stable prices. The U.S. terminal rate has been trending downwards – driven by an aging population, growing debt burdens and a slide in productive capacity and growth rates for the global economy.
This terminal rate trend is a signal that we could possibly see a challenging combination of rising inflation and rapidly growing fiscal stimulus in the future. For us, that is a clear case for reducing longer-term bond exposure.
At this time, we are modestly lowering the exposure to risk in our portfolios.
While we expect equities to generate superior returns relative to fixed income, we have slightly reduced our overall allocation to equities, but remain overweight. We believe equity markets already reflect much of the good news we anticipate regarding the global economy. With that being said, we believe the backdrop of recovery and ongoing growth is likely to continue as COVID-19 vaccination progress accelerates.
Within our fixed income position, we maintain a short duration bias – what this means is our bond portfolio is less sensitive to interest rate changes.
For more information, please do not hesitate to contact your MD Advisor*.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.