It’s been a volatile ride for the US fixed income market through the first half of 2021. After interest rates seemed to be more or less “renormalizing” in their climb back to pre-pandemic levels, the US Treasury market rallied: In the span of three months, the yield on the 10-year note dropped from 1.74% on March 31 to 1.45% on June 30.
To many market participants, this downward move may seem counterintuitive. US economic activity has continued to pick up with the widespread, successful rollouts of the COVID-19 vaccinations. Accommodative monetary policy along with generous fiscal policy should be a strong tailwind to economic growth into the second half of 2021 and beyond. And inflationary pressures have clearly increased over the past few months.
In theory, all of this should translate into higher interest rates, but that hasn’t been the case. So why have rates fallen off their recent highs, in spite of improving economic conditions?
The “consensus trade”
Being “short” rates, or underweight duration, was a popular market-consensus trade at the end of March:
- A number of market participants, including hedge funds, were positioned for higher rates. In such an environment, even small moves lower can trigger a rapidly escalating rate rally as leveraged investors attempt to cover their risk.
- Moreover, most of the primary dealers themselves had little duration available on their balance sheets to provide to investors, thus accelerating the rally (Figure 1).
- The early months of 2021 were also characterized by weak overall Treasury auctions, “feeding” the market consensus on overall lack of appetite for duration.
The latest numbers show that foreign investors have continued to ramp up their purchases of US Treasury securities. Not only are US interest rates higher than those in much of the developed world, including Japan and Germany (which have negative or zero rates on parts of their yield curves), but foreign-exchange hedging costs for these investors are low on a historical basis as of this writing.
Many pensions have rebalanced into longer-duration Treasuries as their funding ratios have improved due to more robust equity markets. I see a proxy for this activity with the recent increase in “stripping” within the Treasury market. “STRIPS” are Treasury bonds that have been decomposed into their separate principal and interest components and are often used by liability managers seeking to target duration and cash flows for their liability-matching needs.
US economic data overall still offers a somewhat fuzzy picture on whether the realized inflation we have seen is likely to be “transitory” (as per the Fed’s latest guidance) or more persistent. And given this year’s market consensus, it will be difficult for the data to outpace expectations. Meanwhile, the political will in Washington for additional fiscal stimulus appears to be flagging. Treasury Inflation-Protected Securities (TIPS) breakeven rates have dipped correspondingly lower.
- It’s clear that the path to higher rates will not be linear, especially with rates having already risen over the past six to nine months.
- I see opportunities in securitized credit, bank loans, select emerging markets, and inflation assets. I believe actively managed fixed income strategies can best take advantage of these opportunities. Long/short strategies can serve as complementary allocations.
- Critically, the potential upward trajectory of rates over the course of 2021 may provide an additional income “cushion” for fixed income investors in the event of future risk-off or “flight-to-quality” market episodes.