By Joanne Benson, Portfolio Manager at Copia Capital Management
The first quarter of the year has been all about the bond markets, but unfortunately for bond investors it has not, on the whole, been a happy start to the year. Government bonds and other ‘safe haven’ assets fell out of favour during the quarter, with the sell-off intensifying after Joe Biden entered the White House in late January. Might the Fed and the President’s stimulus packages prove too much for the US economy? Bond markets seem to think that it might.
Biden’s intentions were clear from the outset: Even before officially taking office he had expressed a desire to “go big” with a huge $1.9trn stimulus package, dubbed the American Rescue Plan. As the final seats in the US election fell to the Democrats, it looked like Biden could have sufficient numbers to push through his plan, which was formally approved in March. With the US also engaged in a push to ramp up vaccinations, markets did not wait around for confirmation; the response was swift and bonds fell sharply in February.
The ‘reflation trade’ has partly reflected a better outlook for the US economy. A reopening of the economy supported by consumers who are 1. vaccinated (increasingly) and 2. have squirrelled away an estimated $1.6trn in extra savings. They are now ready to start spending. While everyone is in agreement that inflation will rise in April and May, reflecting the improvement today vs economies that had stopped in their tracks 12 months ago, the Fed believes the higher inflation figures, which may top 3% in the US, will be transitory. Markets meanwhile have been less certain and have adjusted to price in some risk that a combination of government sanctioned stimulus, household savings, and low interest rates could lead to an overheating of the economy. In all this there has been a consistent message from the Fed, which is still engaged in QE, that it is not entertaining the idea of higher interest rates this year.
What does this mean for bond portfolios?
US 10yr breakevens finished the quarter at 2.4%, putting them in line with long term averages. While this suggests higher inflation over the coming decade than the US has experienced over the past decade, higher levels of growth and the Fed’s willingness to let inflation run above target could support this view.
In the UK, breakevens increased to 3.6%, partly reflecting a change in the benchmark but also reflecting the potential for higher inflation in the next few years. With sterling also strengthening recently, we are cautious about adding to UK index-linked positions. There is also additional risk that a future change in the inflation calculation for these bonds would leave investors out of pocket.
Crucially, so far this year, index linked bonds have not offered investors the protection they might have expected from a bond that incorporates an element of inflation protection. This was particularly pronounced in bonds with longer maturities. Other options for bond portfolios include reducing duration or scaling back exposure to bonds in favour of other asset classes. Within the bond universe, high yield bonds may offer some value given the outlook is for lower defaults, but these may not be appropriate for those with a lower appetite for risk. Asset backed securities may also be worth considering as the floating rate nature of ABS can shield investors against higher interest rates. However, it’s worth noting that the pace of the sell-off slowed from March and into April. Yields appear to have stabilised somewhat with data that might unsettle bond markets, such as strong US employment numbers and higher inflation figures, failing to cause major upset. This suggests that, barring major developments around vaccine roll-out / effectiveness, most of the reflation move may have played out for the time being, although investors may still look to review their exposure to the asset class over the longer term.