25 February 2021
Rates pain vs. credit gain
While central banks may keep rates anchored to support the recovery, Treasury yields are rising in an environment of rising growth and inflation expectations.
Fundamentals
The market is pricing in a path of higher growth, and tail risk seems to be diminishing from a virus perspective. Case growth has slowed significantly across most countries and evidence is pointing to the vaccines being effective in reducing infection. In the US, growth expectations have been revised higher, with the average 2021 GDP forecast now above 6%. Fiscal stimulus is supporting growth for now, with more support expected to come through the year. But by mid-2022, the reopening is expected to outweigh fiscal support as the primary determinant of the level of real GDP. These factors are all contributing to higher yields, with the market now beginning to price in interest rate increases (with more than 0.5% of Federal Reserve hikes priced in by the end of 2023). With a higher inflation narrative forming (at least in the near term), the reaction function of central banks will be a key factor to monitor. For now, we expect central banks to hold the line and keep monetary policy easy in order to support the recovery and allow governments to fund higher debt burdens incurred during the pandemic. Easy policy should ultimately act as an anchor for rates.
Quantitative valuations
Recent rate moves have caused government bonds to underperform significantly. As the US 10-year yield has moved from 46 basis points (bps) to 1.36%, the US Treasury index has returned -4.1% year to date. The pain is not confined to government bonds. High quality credit, with a longer duration of 7.2 years, has returned -2.4% YTD. In contrast, other fixed income sectors further down the risk spectrum have fared relatively well, thanks to their lower duration and higher spread: with a starting option-adjusted spread of 410 bps and a duration of 3.7 years, the total return for global high yield in 2021 has been 0.95%. Breakeven levels in certain markets are still supportive. At the current spread of 371 bps, for example, high yield can absorb a further 100 bps rate increase before total returns turn negative. (All data as of 24 February 2021).
Lower duration spread sectors have been able to absorb higher rates
Source: Bloomberg, J.P. Morgan, Barclays Live; data as of 24 February 2021. IG = investment grade; HY = high yield; EM = emerging markets.
Technicals
One potential upside risk for Treasuries that is worth monitoring is that positioning appears to be short across the market, suggesting an element of consensus in the expectation of higher yields. However, the technical environment has not changed: low core bond yields on an absolute basis mean that investors are still looking for places to invest cash, and this grab for yield should continue to benefit spread sectors. One thing worth noting is that certain market conditions have helped keep yields and prices stable. In emerging market corporates, for example, a smaller market and fewer trading opportunities has helped the sector to hold up relatively well.
What does this mean for fixed income investors?
Ultimately, we think markets are justified in expecting higher rates, given the progress on the vaccine, continuing signs of economic recovery and higher inflation expectations. It makes sense to express this view via steepeners or short rates positioning, though investors should be mindful that, for now, central banks are likely to keep a lid on rates. Our preference is for spread sectors, where the interest rate sensitivity is lower. We expect high yield and select emerging markets to be well-supported in this environment.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum