Life after the vaccine: bond market recap and possibilities/expectations upon reopening
Part four of a five-part series
By ATB Wealth 18 June 2021 5 min read
In part two of this series, we reviewed the economic and government responses from the pandemic. Now, let's try to answer the question; what does this all mean for an investor? Looking at how bond markets have reacted, and how they will continue to react, is probably the easiest way for us to relate to the high-level economic predictions, especially when talking about monetary stimulus.
To summarize part two quickly; savings have built significantly through the past year. The central banks are keen on leaving the stimulus taps open, focused squarely on getting back to full employment. Vaccines are on pace to warrant the likely end of government-mandated lockdowns by summer, and all that excess cash could find its way back into the economy as individuals look to make up for time lost during the pandemic.
Taken together you have what could be a perfect storm for reversing the trend of decreasing inflation that has been in place since the early 80s. Markets tend to be good at factoring-in expectations, so let’s look at what has happened so far in 2021 while anticipating this cash spend upon reopening and possible elevated inflation.
Bonds and inflation since the start of 2021
For bond markets, post-recessionary periods would typically see higher, longer-term interest rates. The theory behind why that occurs is that demand from growth will lead to higher inflation. Higher inflation is a primary component in a bond’s yield, so the yield increases. Higher yields result in lower bond prices—since there is an inverse relationship—which has been the case this year.
Demand is expected to pick up, with individuals and households spending cash as the economy reopens, driving expected growth and inflation.
Bond yields subsequently move up to compensate buyers for the inflation and growth. Existing bond holders that bought at lower yields earlier in the year, and who are looking to sell, would have to do so at a higher yield and, in turn, a lower price. This has, in fact, materialized into bonds returning -4.4%1 to the end of May 2021 in Canada.
So rates have increased, but how much of that has been due to inflation expectations? There was much talk in the news about higher inflation for the foreseeable future, but is that really what markets think?
One way to assess this is by looking at the breakeven rate2. In the US, this rate is telling us that the market is expecting to see, on average, about 2.45% inflation over the next 10 years (up from 1.98% at the end of 2020). While inflation expectations are now over the 2% Federal Reserve target, they still are not out of line with expectations seen in the mid 2000s and early 2010s, during the post recessionary periods coming out of the tech bust and financial crisis.
US 10-year treasury yield and the 10-year US breakeven inflation rate
Breakeven rates are not a foolproof method of forecasting inflation, but looking at what the market expects can at least give some longer-term guidance on where to go from here. Shorter-term breakeven rates are higher than what is expected from the 10-year, with the 2-year at around 2.8%. This tells us that higher levels of inflation are expected to be short-lived, and after the economy “returns to normal,” inflation is expected to be closer to what the Fed is targeting over the longer-term. It’s also worth mentioning that the Fed changed its stance in the summer of 2020 to target an average of 2% for inflation, so long as it’s meaningfully around that 2% target. The 2010-2020 decade averaged 1.7%3 for inflation. Seeing 2-2.5% for 2020-2030 would bring the Fed back on target for the long-term 2% average.
For Canada, it’s likely that we will see similar levels of inflation (the 10-year breakeven inflation in Canada was at 1.86% as of the end of May 2021). As the Canadian and US economies typically tend to move in the same direction, the Bank of Canada can be expected to continue taking a similar policy approach.
Looking forward - how to position a portfolio for the possibilities
The threat of inflation has been somewhat of a thorn in the side of the market over the past decade, despite never materializing. But now, given the government spending to buoy the economy through the pandemic, and the apparent glut of spending that will follow upon re-opening, some are thinking inflation is a sure bet. Before getting ahead of ourselves though, inflation—and what could prompt it—has largely eluded academics and market participants for years now. This too may turn out to be a fake-out.
Whether inflation rises or not, an investor can position the fixed income component of their portfolio to hopefully do well in either environment.
For bond investors, increasing interest rates and inflation don’t have to mean negative returns. Shorter duration bonds, while yielding somewhat less today, can be rolled over at higher rates more frequently. A higher exposure to corporate bonds can help to compensate for the lower yield that shorter term bonds generally offer. If inflation doesn’t occur, the higher yield can cushion the effects and still target a reasonable rate of return for the fixed income investor.
Does it pay to be long duration in a rising environment?
1950-1980 US Government bond returns before inflation
If inflation does occur, causing rising yields, the ability to roll bonds over quickly from shorter duration becomes vital to ensuring a positive return over inflation. Short-term, medium-term, and long-term government bonds have accurate return data over the 1950-1980 period. Inflation and interest rates steadily increased throughout the three-decade period; both impact bond returns negatively, but this is especially true for long-term bonds. As shown in the chart below, adjusting for the impact of inflation, long-term bonds lost more than 40 per cent of their value over the 30-year period. In this rising interest rate and inflationary environment, short-term and medium-term bonds both outperformed long-term bonds consistently. Corporate bond data split out by maturity is not as reliable prior to 1980, so it is not captured in this example. However, the additional yield offered can help to buffer the expected return with short-term and medium-term bonds.
Does it pay to be long duration in a rising environment?
1950-1980 US Government bond returns net of inflation (real returns)
Adding corporate bonds should be done carefully since there is higher risk, but the higher yields do generally more than compensate for that inherent risk over time. Focusing on companies that are able to manage their business appropriately—with rising prices and interest rates—becomes even more important.
With a long-term perspective, facing an environment of rising yields and elevated inflation, it is important to consider all the tools available to protect against inflation. Short-term bonds with a corporate bias may be a solution to at least keep pace with inflation, but returns going forward are still anchored by the relatively low starting yield. Bond returns can’t be as high as they have been over the past 30 years. Stocks, which will be covered in the next part of the ‘Life after the vaccine’ series, can be a part of the solution to not only protect against inflation, but also offer some over and above return.
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Total return of the FTSE Canada Universe Bond Index from Dec 31, 2020 to May 31, 2021.
The breakeven rate is the difference in yield between a government’s treasury bond and inflation linked bond of a similar maturity. One could argue that the central banks buying longer term bonds distorts this data, but similar expectations can be found from other sources such as inflation and CPI swaps, as well as the University of Michigan CPI surveys.
Annualized rate derived from the US CPI Urban Consumers non-seasonally adjusted index. Bureau of Labor Statistics. Dec 31, 2009 to Dec 31, 2019.
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