It is far too early for taper talk, in our view, but the bias of risk is still toward higher rates to come.

Readers of our latest Fixed Income Investment Outlook may already know that we came into 2021 with three major themes, the first of which was to maintain a laser focus on seeking out yield and income without duration.

Our view is that, in investment grade credit, low yields coupled with long durations create downside risk even for bonds with positive credit fundamentals. We think portfolios should emphasize high yield, loans, collateralized loan obligations (CLOs) and other sectors that still offer some yield with minimal interest-rate exposure.

The U.S. 10-year Treasury yield has doubled since it began its march upward last August, and now stands at around 1.10%. Almost 20 basis points of that charge has come since the start of this year. The arrival of coronavirus vaccines had already fueled optimism over economic reopening, the confirmation that the Democrats will exert narrow control over both Houses of Congress added fiscal-stimulus accelerant to the fire, and recent talk of “tapering” from Federal Reserve heads provided the oxygen.

Could that mean we are seeing the start of a melt-up in rates? We don’t see it that way. That means we still like the look of credit, and we still see more downside than upside risk in duration.

Return to Normality

We do think rates are likely to go higher this year, but we anticipate a 10-year U.S. Treasury yield of around 1.25% in three months’ time, 1.35% in six months and only 1.50% by year-end.

Today’s level of 1.10% is still lower than our estimate of fair value coming into the fourth quarter of 2020—which is to say that we still haven’t seen a true normalization of rates after last year’s rush to safety. In fact, the adjustment has lagged the rise in inflation expectations: U.S. real rates have declined since November, when the coronavirus vaccines arrived on the scene. The picture is still more becalmed in the Eurozone, where core government yields have barely moved over the past three months.

While there was no “blue wave” back in November, confirmation of a “blue ripple” in U.S. government is significant for the fiscal outlook.

Markets had priced in much of the Biden election campaign’s economic platform before he unveiled his $1.9 trillion formal plan last Thursday. The effect of that was not to bring its pricing for the end of zero-interest-rate policy forward to 2021, or even 2022, but to bring it forward from 2024 to 2023. Expectations that a narrow majority will likely delay or prevent some proposals from being implemented meant that Thursday’s details did little to move bond markets further. Moreover, retail flows into fixed income remain resilient, and that is working its way into bond auctions: The U.S. Treasury received plenty of demand for its 10- and 30-year issuance last week.

What about the taper talk? It has actually been a somewhat mixed message, with some normally dovish Federal Open Market Committee members hinting that it might be time to discuss policy adjustments later this year, some normally hawkish members dismissing any immediate threat from inflation, and all points in between.

Put the unusual unanimity of 2020 aside, and this, again, could be characterized as a return to normalcy for central bank watchers. We do not regard this as “signaling,” let alone a departure, from the current policy trajectory.

Income Without Duration

The recent bounce in rates has offered little to frighten the horses, therefore, and we expect central banks to continue soothing markets rather than disrupting them this year, too. We view recent moves as a fairly orderly adjustment of bond prices to improved growth and inflation expectations.

That still doesn’t make a case for interest-rate risk in portfolios, in our view, but it does make the outlook for higher-yielding parts of the credit markets very favorable. There are likely to be volatile days and weeks ahead, but on a 12-month view we continue to emphasize that key theme of income without duration.

In Case You Missed It

  • U.S. Consumer Price Index: +0.4% in December month-over-month and +1.4% year-over-year (core CPI increased 0.1% month-over-month and 1.6% year-over-year)
  • U.S. Initial Jobless Claims: +965,000 for the week ending January 9
  • U.S. Producer Price Index: +0.3% in December month-over-month and +0.8% year-over-year
  • U.S. Retail Sales: -0.7% in December month-over-month

What to Watch For

  • Monday, January 18:
    • China 4Q 2020 GDP
  • Wednesday, January 20:
    • NAHB Housing Market Index
    • Bank of Japan Policy Rate
  • Thursday, January 21:
    • European Central Bank Policy Rate
    • U.S. Initial Jobless Claims
    • U.S. Housing Starts and Building Permits
    • Japan Consumer Price Index
    • Japan Purchasing Managers’ Index
  • Friday, January 22:
    • Eurozone Purchasing Managers’ Index
    • U.S. Existing Home Sales

– Andrew White, Investment Strategy Group

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