In his latest commentary, Brad Tank of Neuberger Berman ventures a long-term view of the U.S. bond market. Tank expects U.S. 10-year yield to gradually rise to about 1.5% in 2021. That could put pressure on bond markets and the Federal Reserve.
After Democrats won the Georgia Senate runoff election in early January, the likelihood of additional government spending also increased, which was simultaneously reflected in market expectations for rising U.S. interest rates. "When the Corona crisis is finally over, it is expected, expansionary fiscal policy will boost not only growth but inflation – and perhaps the Federal Reserve's (Fed) loose monetary policy will tighten more quickly", means Brad tank, CIO Fixed Income with Neuberger Berman.
Growth and inflation, and therefore interest rates, are likely to depend on the pace, extent and structure of the new stimulus package that Congress is likely to pass. While the Republican proposal only provides for 618 billion. USD aid ahead, but Democrats may now push their 1.9 trillion package through the House anyway.
Plans include consumer checks worth $1,400 per person and an increase in the minimum wage to $15 per hour. "If this such a large package were actually passed, the Treasury would likely have to issue more bonds. Growth and inflation are also likely to rise more strongly. And then we can also expect a more rapid normalization of long-term yields", says Tank.
Signs of reflation
Gross domestic product (GDP) is expected to grow strongly in the second half of the year and early 2022, he said. The 935 billion. U.S. dollar-heavy package from December is then likely to have an effect, as is the extensive new aid currently being debated by Congress. In addition, there is a considerable backlog of demand. "As we get closer to herd immunity through vaccinations, consumers, perhaps around mid-year, are likely to increase their spending as well", the expert expects.
There are already signs of reflation in the U.S.A. If unemployment declines in the coming weeks, rents would likely rise again as well. This component of the consumer price index has been very weak recently. In addition, there are base effects. Around the middle of the year, the low inflation of the previous year should show up in the figures. But the big question, Tank said, is why real yields are not rising in tandem with these reflation dynamics.
As CIO Fixed Income goes on to point out, real yields tend to decline when the debt-to-GDP ratio rises, which is the ratio of government debt to GDP. Bond markets react to concrete numbers. The assumption is that a highly indebted government has nothing to oppose higher inflation and that government debt crowds out growth-enhancing investment – unless GDP shows otherwise.
Conversely, real yields could gradually rise if there is no longer any doubt about the support from fiscal policy and the vaccination campaigns go off without a hitch. The economy may then reopen and grow above the long-term trend. Then, according to Tanks, nominal yields can be expected to react quickly – and with them real yields as well. Last but not least, higher government bond issuance to finance the unprecedented stimulus programs will also show up in prices.
Higher term premiums on the horizon?
"But foreign investor demand for U.S. government bonds could limit the rise in yields. When the Fed finally does respond to the new inflation dynamics, it will likely act more decisively than the market suspects. Nevertheless, market participants are probably right to expect this to happen only in a few years' time. This year, however, low short-term interest rates and longer average maturities of U.S. government bonds could make for a much steeper U.S. yield curve", Tank says.
This steeper curve could offer foreign investors in the U.S. a much higher term premium than they would likely receive in their own bond markets, and with a fairly favorable currency hedge on the USD. The question, Tank said, is whether the inflows of non-U.S. investors into U.S. government bonds will be enough to prevent a significant rise in yields on long-dated bonds.
Demand from abroad could dampen the term premium in the U.S. But it does not change the economic trend or the Fed's stance – and thus the expectation of rising yields, he adds. "We therefore prefer inflation-indexed securities and are focusing on below-average duration in our portfolios as the year progresses", says Tank.