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Fixed Income Commentary

January, 2021

4th Quarter 2020 Fixed Income Review

Fixed income markets had generally positive performance in the 4th quarter of 2020 and returns for the year were quite good considering the historically low rates available and U.S. equity markets hitting all-time highs. A better outlook for global growth in 2021 and continued benign inflation were contributing factors. Additionally, world central banks, including the U.S. Federal Reserve, signaled more accommodative policies, with the latter cutting the overnight rate from 0% to 0.25% in March.

Below are some 4th quarter and 2020 Bloomberg Barclays fixed income index returns:

The 10-year U.S. Treasury (UST) Note, a bellwether measure used in the fixed income markets, ended 2020 with a yield of 0.91%, a marked decrease from 1.92% the previous year. That said, 91 basis points were extravagant compared to the 10-year UST yield record low of 0.51% posted in early August. As of the time of this writing, the 10-year U.S. Treasury yield exceeded 1.0% for the first time since early March.

The UST yield curve “steepened” during the year as short-term yields fell more than longer-term rates in response to the U.S. central bank’s emergency cuts in March. Global bond yields declined in general. It is important to note, the 2-10-year UST yield spread differential, an often-cited measure of the slope of the yield curve, ended 2020 at 79 basis points, the widest measure since 2017. That same yield spread has averaged around 60 basis points for the past five years. We believe the Treasury markets are beginning to digest the likelihood of greater Treasury issuance following a continuation of emergency and ongoing stimulus spending out of Washington. A steepening yield curve and rising interest rates are a textbook response to a perceived increase in supply.

The chart below shows the changes in the UST yield curve from the end of 2019 (gold line) and the end of 2020 (green line). The bar graph at the bottom shows the changes in yields for select maturities.

In their most recent meeting in December, the FOMC left interest rates unchanged and signaled that they would continue emergency asset purchases ($80 billion in Treasurys and $40 billion in mortgage-backed bonds per month) “until substantial further progress” has been made toward their goals of full employment and a 2% inflation rate.

At their December meeting, the FOMC also updated predictions for GDP, inflation, and unemployment. Interestingly, the Fed’s median estimate for the core Personal Consumption Expenditures (PCE) Index, the central bank’s preferred measure of inflation, is expected to be below their inflation target of 2% until 2023. The median estimate for GDP in 2021 is 4.2% and 3.2% in 2022, both projections are slight improvements from their most recent estimates. The unemployment rate is expected to be 5.0% in 2021 and 4.2% for the two consecutive years after 2021.

Despite the FOMC’s published expectation that inflation will remain below 2% until 2023, the bond market’s inflation expectation over the next decade, as measured by the current 10-year UST breakeven rate, has recently increased to over 2% for the first time since 2018. Notably, the FOMC recently stated it will now allow inflation to run slightly higher than its 2% policy target as long as the average inflationary reading remains near 2%. This more accommodative policy shift signals a new and more flexible central bank approach, versus previous regimes, where the FOMC has acted expediently to extinguish any sign of reading above their target inflation level. With portions of the fixed income and equity markets rebounding, in some cases surpassing their pre-COVID-19 highs, it is clear the financial markets are factoring in the effects of an extremely accommodating Fed.

Sovereign bond yields generally declined in Q4 2020 (except in the U.S.) amid uncertainties brought about by a resurgence in COVID cases in certain regions and continued central bank intervention. Globally, negative-yielding debt increased to almost $18 trillion during the quarter.

The U.S. fixed income markets have yet to experience the negative yield phenomenon felt in Europe and Japan, and most domestic pundits, as well as members of the FOMC, do not expect negative interest rates in the U.S. At present, the use of negative interest rates is an extraordinary monetary tool being implemented by some central banks with untested results and unknown long-term repercussions.

Below, in blue, are 10-year bond yields from several foreign countries (sorted from low to high). Note the wide difference between the yield of the bellwether German Bund (the German ten-year note) at -0.60% compared to the U.S. ten-year note at 0.92% currently. This marked disparity in yields is indicative of divergent monetary policies as well as differing economic outlooks both domestically and abroad.

While always seeking opportunities during periods of market dislocation, we continue to recommend that our core fixed income portfolios maintain high credit quality and shorter, more defensive, durations. Although the Federal Reserve has indicated it will continue with direct purchases of Treasuries and mortgage bonds in the open market in an ongoing effort to maintain artificially low-interest rates, recent U.S. Treasury market observations, mentioned earlier, indicate some consternation by bond buyers to continue to accept historically low rates ongoing. In the face of heightened Treasury issuance, a possible change in the political winds in Washington, and the prospect of even a moderate increase in the rate of inflation, we continue to see some steepening in longer-term yields (yields and bond prices move in opposite directions).

As mentioned in our previous quarterly review, these are very unusual times in the financial markets. An unprecedented amount of central bank intervention with historically low (and even negative) interest rates, as well as overt political pressure for added accommodation at a time when sovereign deficits balloon to historic levels globally, is a challenging environment for a bond buyer. In following, for most fixed income accounts, we currently recommend a broad diversification of strategies, both conservative and more opportunistic, as a means of preserving capital, creating cash flow, and pursuing positive risk-adjusted returns. We hope you will contact your portfolio manager, or any member of our fixed income team, to discuss our thoughts on fixed income in general, and to learn more about opportunities we believe are both appropriate and timely.