Fixed Income Commentary – April 2021

“Anticipation”

Carly Simon


Key Takeaways

Intermediate and long-term bond yields continued their ascent in March.  Bond yields are rising for all the right reasons- economic activity is improving, fiscal policy is taking the baton from monetary policy, and financial conditions are supportive.  There is widespread anticipation for higher inflation in the short term, but we expect it will prove to be short-lived rather than the start of a long-term trend.

March in Review

  • The 10-year Treasury yield finished the month with a yield of 1.74%, up 34 bps month over month.
  • High yield was the only fixed income sector with a positive total return on the month, +0.15%.
  • With the strong move higher on the back end of the Treasury yield curve, Treasuries finished the month down 1.54% in total return.

 


Commentary

Bond yields rose in March as the vaccination effort gathered momentum in the U.S., and once again the action was predominantly in five year and longer maturities.  We continue to view this development favorably since yields should no longer reflect the emergency-like conditions of 2020 now that a clear path forward for economic recovery is in sight.  Bond yields are rising for all the right reasons — economic activity is improving, fiscal policy is taking the baton from monetary policy, and financial conditions are supportive for a broad-based recovery.

Our title this month refers to the widespread anticipation of higher inflation that will soon be reported for which there is an obvious explanation: base effects.  Many prices of products and services plunged last year — think oil and auto insurance — due to the pandemic and the sudden shut-down of the economy.  As those large price cuts fall out of the year-ago comparisons, the year-over-year figures will likely appear large, but a longer term look will reveal no big increase.  Anticipation of this jump in inflation is widespread but the human tendency to extrapolate recent data, combined with the latest economic relief package, has caused many to raise alarm over the rising inflation.  We do not anticipate the trend to persist and expect it to be transitory, much like Fed Chairman Powell expressed in his recent appearance in Congress.

Inflation will require more than a few one-time price hikes in order to become a sustained trend, and the supply bottlenecks now evident due to the pandemic should soon give way to more normal supply-demand patterns.  Some think that 1970s-style inflation will soon grip the nation, but it should be remembered how many seminal events were required for that episode to occur: the end of the gold standard, high deficit spending to fund the Vietnam War, expensive new social spending programs, and the oil crisis, to name just a few.  All of these occurred before globalization and the myriad innovations that make today’s economy much more dynamic compared to the ‘60s and ‘70s.

Not only did it take a lot to create the inflation of that era, but a glance at the countries experiencing rapid inflation today is also instructive — Venezuela, Zimbabwe, Sudan, and Lebanon lead the way.  None of these countries features the deep trade relationships or robust markets for goods and services of the developed world.  And let’s not forget the Amazon effect, which provides price transparency for consumers and continues to drive prices lower for many goods.  For these and other reasons too dense for this piece, we do not expect a run-away inflation problem in the U.S. any time soon.

Anticipation is also apropos in the context of the recovery from the pandemic that we are all eyeing with delight, although the recent spike in infection rates and the stubborn number of deaths stand as reminders that some risk remains.  This recovery will surely be memorable due to the combination of pent-up demand and the repetitive federal stimulus payments.  The federal stimulus provides the consumer, state/local government, and small business sectors with the means to spend, and the spending will likely be spread out over many months.

Anticipation is evident in the 13+ point jump in the Conference Board’s monthly index of consumer confidence.  On March 30, this index rose to its highest reading in a year, likely in reaction to the swift progress on vaccinations and the $1.9T fiscal stimulus which has started to hit bank accounts.  Higher vaccination rates in the second quarter should lead to higher consumer spending as the home-bound venture out once again.  Lastly, it seems apparent that above-trend economic growth is in store for 2021 and perhaps longer if even just some of the new infrastructure proposals from the Biden administration are implemented, and this too will be a multi-year impact.

With so much positive change anticipated by so many, it is important to ascertain what is factored into market prices while at the same time considering what risks may lead to different outcomes from the expectations of market participants.  Given the marked repricing of 5 year and longer Treasuries, we believe some attractive opportunities have developed, primarily in the corporate and municipal sectors.  With many corporate management teams expressing a commitment to debt reduction, we are encouraged that debt metrics will start to improve as revenue returns to normal for many.  Similarly, the federal stimulus will allow municipal budgets to come into line while also enabling some capital spending.  Bond ratings could benefit from both of these trends, whether from the avoidance of downgrades or from upgrades due to better results.  Just last week, Moody’s upgraded the State of Connecticut’s bond rating for the first time in twenty years, something that probably would not have occurred absent the federal stimulus.

There is much change afoot now that a new administration is focusing on bold initiatives.  This could alter the future path of the economy and we are encouraged by the rising sense of optimism.  It is our hope that the rising debt load of the federal government, and the rising cost to service it, will not inhibit the upbeat outlook.