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Rates Are Rising, but Should Bond Investors Be Worried?

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What You Need to Know

  • Kathy Jones at the Schwab Center for Financial Research and Kevin Flanagan at WisdomTree discuss their outlooks.
  • They expect bond yields will continue to rise as the economy recovers.
  • They are watching for the first sign of the Fed planning to reduce asset purchases.

Interest rates are headed higher and, even if the trajectory is a choppy one, the U.S. 10-year Treasury note is expected to end the year with a 2%-2.5% yield, according to bond strategists.

Its current yield is around 1.60%, up from 0.92% at the end of last year but down from 1.74% at the end of March.

“The vaccine rollout was more rapid and successful than we expected, and the fiscal stimulus was more than twice what we thought it would be … and we expect even more,” said Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research, explaining the overall rise in interest rates.

As a result of the stimulus, which put thousands of dollars into the pockets of most American families, and the vaccine rollout, the U.S. economy rebounded, surging at a 6.4% annual growth rate in the first quarter. The second quarter could be even stronger.

President Joe Biden’s American Jobs Plan and American Families plan would add even more stimulus — close to $4 trillion over eight to 10 years following the almost $5 trillion in emergency aid passed by the Trump and Biden administrations. But those plans are likely to be reduced in size to ensure their passage, even if done through reconciliation, which would require only Democratic votes.

Stronger Economy, Rising Inflation Expectations

“The U.S. economy is off and running,” wrote Mark Zandi in his recent economic update. “Real GDP grew at a boom-like 6.4% annualized rate in the first quarter, and a double-digit gain is more than likely in the current quarter. Consumers led the charge in the first quarter, but business investment and homebuilding were also robust.”

That growth, coupled with rising inflationary expectations and actual inflation, is expected to send rates even higher.

“Inflation is picking up,” Zandi wrote. “The core consumer expenditure deflator, the inflation measure used by the Federal Reserve to determine monetary policy, jumped in March and is back close to the Fed’s 2%-through-the-business-cycle target.”

Some of the jump is due to what the Fed calls base effect, comparing current inflation levels with extremely depressed levels a year ago, but that effect will moderate in time, along with  spiking commodity and industrial prices as supplies rebound and pandemic-induced supply chain problems are solved, according to Zandi.

Fed Chairman Jerome Powell has said repeatedly that rising prices are transitory and that the Fed will tolerate inflation above 2% temporarily so that inflation on average rises to its 2% target.

But Kevin Flanagan, head of fixed income strategy at WisdomTree, notes that the breakeven spreads between the 10-Year Treasury Inflation-Protected Security (TIPS) and the 10-year Treasury note is suggesting otherwise, sitting at 243 basis points, its widest level since 2013. “Ultimately the 10-year Treasury yield doesn’t stop at 2% and probably overshoots,” Flanagan said.

Bond Investment Strategies

Given these expectations for higher yields, Flanagan and Jones both recommend investing in bonds with shorter duration (which have less sensitivity to rising rates) than their usual benchmarks.

More on this topic

“Focus on the reflection trade and rate-hedged type solutions,” such as strategies that short the Bloomberg Barclays Aggregate Bond Index (Agg) and are long high-yield debt, Flanagan said.

Jones favors a laddered approach, which includes shorter- and longer-term bonds between three- and five-year maturities on the shorter side and 12 years on the upper end.

Both Flanagan and Jones favor corporate bonds over government securities because of their relatively higher yields and the supporting economic outlook.

“This is a great environment for credit — a very easy Fed, an economy that’s rebounding and a lot of fiscal support,” Jones said. “It doesn’t get much better than that.”

But neither Jones nor Flanagan expects the spread between corporates and Treasurys will narrow much to yield big capital gains.

They both also like emerging market debt because of relatively higher yields, but Jones said that what happens to emerging market debt will depend on the economics of individual countries and their currencies, especially if the debt is denominated in local currencies.

Bond Market Outlook

As for the future bond market outlook, both Jones and Flanagan are watching for the first indication that the Federal Reserve is preparing to reduce its monthly asset purchases of $120 billion in Treasuries and mortgage-backed securities. Jones expects the Fed announcement will come by year-end, but the bond market may expect it sooner than that.

“The market feels as if the Fed’s outlook doesn’t match its own,” Flanagan said. “What the market is looking at — and which it didn’t have before — is the magnitude of fiscal spending that’s looming on the horizon … which is adding more fuel to the economic engine that could potentially overheat.”

Treasury Secretary Janet Yellen, in an interview with the Atlantic magazine that was broadcast online Tuesday, said: “It may be that interest rates will have to rise somewhat to make sure our economy doesn’t overheat. … It could cause some very modest increases in interest rates.” Later that day, Yellen downplayed her comments about potentially higher interest rates. “It’s not something I’m predicting or recommending.” She also said she doesn’t foresee an “inflationary problem, but if there is [one], the Fed will be counted on to address them.”

Jones is watching for indications of inflation expectations from TIPS breakevens, the CPI swap market and surveys. “All are indicating that expectations up for the next year or so but flatten out after that — perfect for the Fed’s transitory inflation view and the Dow,” said Jones.

(Pictured: Kathy Jones of Schwab)