Throughout much of 2020, the lion’s share of attention was focused on equities — as stocks suffered one of the sharpest declines in a generation due to Covid, subsequently followed by one of the fastest rebounds stimulated by extraordinary levels of monetary and fiscal accommodation that was provided for the recovery.
With the economy on the mend, the Fed has been, in their words, “putting some of their tools back in the toolbox,” while generally continuing a very accommodative policy posture. The majority of the heavy lifting is now being done by fiscal policy, and we have seen multiple trillion-dollar stimulus packages rolled out over the past several quarters.
This has led to an improved economic outlook for the years ahead, and investors are pricing in higher levels of growth and inflation going forward. As a result, investors are selling bonds in anticipation of higher levels of inflation. Selling has been most pronounced in longer-dated bonds, leading to a steepening of the yield curve.
This has been somewhat of a stealthy bear market in bonds, as it hasn’t received nearly as much attention from the media as a comparable decline in equities would usually garner. Given how low yields were throughout much of 2019 and 2020, our general recommendation over the past couple years has been to keep duration risk in fixed-income portfolios in the shorter to more intermediate parts of the curve — that way if yields rise as the economy recovers, the declines in price will be more muted, and that has largely played out.
Keep in mind that a rise in yields isn’t necessarily a bad thing, as many retirees rely on a fixed income for “income,” and thus, the ability to purchase higher-yielding instruments can be an advantage when viewed through that lens. Additionally, certain sectors of the stock market can also benefit from higher yields, as long as the move is orderly, and does not result in significant financial market dislocations. Banks, and in a broader sense, value stocks, tend to do better when yields are rising in anticipation of a cyclical recovery, much as they have been over the past several months.
In terms of the implications of higher yields on the overall stock market, the effects are a bit murkier. As discussed in prior pieces, major indices like the S&P 500 have become heavily tilted toward growth and technology stocks, and thus, if yields continue to move higher from here, the momentum that broader indices have enjoyed since March of last year may begin to slow.
Looking ahead, the path of yields is going to be largely determined by the strength of the economic data over the next few months, along with any policy actions by the Federal Reserve. The Fed continues to buy $120 billion in bonds every month, which is helping to keep yields lower than they otherwise would be. We expect this policy to continue for the foreseeable future, given recent communications from Fed officials. The Fed is OK with higher yields in the back end of the Treasury curve, as long as it doesn’t begin to meaningfully tighten financial conditions, thus short-circuiting the economic recovery. So far, that hasn’t been the case, but with mortgage rates already beginning to rise notably, the increase in yields is clearly starting to have an effect. If credit spreads begin to widen, and equity indices decline notably, the Fed is likely to intervene in one capacity or another.
Possible options on the table include “Operation Twist,” which the Fed has used before. This entails the Fed shifting their bond buying from the front end of the curve to more intermediate or longer-dated maturities, thus providing additional downward pressure on yields. A second option would be “yield curve control”, which is where the Fed would actively target particular levels across the yield curve (say 2.25% on the 10-year treasury yield) and not let yields rise above that threshold. Some countries, such as Australia, are already using yield curve control to help suppress rising yields. Both of these options have been discussed by strategists and Fed-watchers, and there are pros and cons to each. So far, the rise in yields doesn’t justify the use of these tools in the U.S. but given the uncertainty with respect to the inflation outlook over the next few years amidst record-setting levels of fiscal stimulus, it is quite possible that Fed policy begins to shift in this direction.
Overall, we are optimistic about the economic recovery in the years ahead and will be closely monitoring the evolution of capital flows as we transition from a more monetary policy-focused paradigm to one where fiscal policy increasingly provides the fuel for the economic machine. In our view, policymakers over the past year were focused on stabilizing the financial system and triaging the economy, and now we are starting to see the shift from Wall Street to Main Street as things begin to normalize. The details are still coming into view, but at a higher level, this is likely to result in higher corporate tax rates and spending on infrastructure and related projects. Amidst this dynamic, we feel that highly diversified portfolios that have exposure to both U.S. and foreign equities, commodities, and high-quality fixed-income exposure of intermediate-term duration are well-suited for this environment.
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