by Olumide Owolabi, Portfolio Manager—Investment Grade and,
Joseph Purtell, Senior Trader and Analyst—Investment Grade, Neuberger Berman
Today’s CIO Weekly Perspectives comes from guest contributors Olumide Owolabi and Joseph Purtell.
To start the year, market expectations of U.S. rates shifted higher on the back of the surprising results of the Georgia Senate runoff elections, which raised the likelihood of additional fiscal spending. Once the lingering effects of the worrisome public health crisis have passed, this spending is expected to drive growth and inflation higher, which could lead markets to reprice for a faster monetary policy adjustment by the Federal Reserve.
Three weeks ago in CIO Weekly Perspectives, Brad Tank played down the risks of a 2021 “Taper Tantrum.” But now we’d like to look just a little further out on the horizon.
We anticipate that the U.S. 10-year Treasury yield will rise gradually to around 1.5% this year, but thereafter we think the pressure may start to build—under bond markets, and also under the Fed.
Stimulus
The level of growth, inflation and, thus, interest rates will likely depend on the speed, size and nature of the additional stimulus bill that Congress is expected to pass. Republicans have countered with a more modest proposal of $618 billion, but Democrats could still force through their full $1.9 trillion package, including $1,400 checks for individuals and a hike in the minimum wage to $15 per hour.
We believe that as the final package approaches $1.9 trillion, there will be more pressure on the Treasury to increase coupon issuance, as well as faster growth in inflation and GDP—and that, once that picture becomes clear, this will likely lead to a sharper normalization in long-dated yields.
We think relatively high GDP data will start to show up in the second half of this year and into 2022. On top of the first signs of traction for the $935 billion U.S. stimulus package passed in December and the outsized proposal currently in the works on Capitol Hill, we anticipate the release of pent-up consumer spending as vaccine programs bring us closer to herd immunity, potentially around the middle of this year.
There are already signs of reflation in the U.S. economy. As unemployment improves over the next few months, we expect the residential rents part of the inflation index which has been below trend to follow. Also, the low base of 2020 inflation is likely to magnify the effect around midyear.
The big question is, why aren’t real yields rising in line with this reflationary dynamic?
Historically, real yields have tended to decline as the debt-to-GDP ratio rises. This reflects the “show-me-the-money” attitude of bond markets: Indebted governments are assumed to turn a blind eye to inflation while crowding out the real engines of growth—until the GDP data prove otherwise.
We think real yields will start to rise when certainty around fiscal support and vaccine distribution is established, leading to a reopened economy and an actualization of above-trend growth. At that point, we believe nominal yields will adjust rapidly, rising to regain a higher level of real yield and finally reprice for the increased supply of Treasuries issued to fund the unprecedented stimulus.
Term Premium
The appetite of non-U.S. investors for U.S. Treasuries could be one constraint on how high yields could go.
When the Fed finally responds to the new inflation dynamic, we believe it will do so more aggressively than the market anticipates. Nonetheless, we do think the market is right not to expect this for another couple of years. This anchor on short-dated rates, combined with a lengthening of the weighted average maturity of Treasury debt during 2021, could make for a substantially steeper U.S. yield curve.
This steeper curve may offer non-U.S. investors a meaningfully higher term premium than they are likely to get from their own bond markets, with a relatively low cost for hedging out U.S. dollar exposure. Could these non-U.S. flows into U.S. Treasuries be enough to prevent a substantial rise in long-dated yields over the next 12 to 24 months?
While non-U.S. demand could compress the U.S. term premium, it does not fundamentally change the direction of travel for the economy, the Fed and, hence, our expectation of higher rates. As such, we favor inflation-protected securities and have an underweight view on duration exposures in our portfolios as we head deeper into 2021.
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