By Marina Mets, head of Americas, fixed income and multi-asset index product management, and Robin Marshall, director, fixed income research
There is a significant reflation trade underway, led by the US, with the yield curve bear steepening as investors look to stronger growth and possibly higher inflation once COVID-19 weakens its grip. Investors are focusing on pent-up consumer demand, a V-shaped recovery and restricted supply-chains in the post-COVID world.
This is evidenced in bear steepening of the 2s/10s, and 2s/30s US yield curve, the rise in US inflation breakevens and tightening of credit spreads. The US Fed confirmed on March 17 that it remains committed to holding rates near zero in 2021/22, until the COVID recovery is secure, but bond vigilantes appear nervous that the Fed may get behind the inflation curve, causing a mini re-run of the 2013 QE Taper Tantrum.
The Biden administration’s fiscal stimulus of $1.9 trillion (about 9% of GDP) has increased inflation concerns, and perceived duration risk in US Treasuries. The Fed’s stated tolerance of a temporary inflation overshoot will not assuage these fears. Nor will the fact that US Treasury yields of 1.5% in the 10-year area are still low historically, even if yields fell to near 0.5% after the COVID-19 shock.
…as stable diversifier and capital preservation asset
For investors looking to park cash in US Treasuries, as a risk-free asset, the duration in longer dated securities creates significant volatility in returns and can mean sharp capital losses if interest rate sentiment changes. In contrast, with the US Fed still committed to near zero rates until 2023, anchoring short yields, short dated Treasuries remain a stable diversifier, and can offer investors safer capital preservation.
Chart 1 (below) shows the performance of the FTSE US Treasury indexes tracking the various segments of the issuance curve. It demonstrates recent modest outperformance on the FTSE US Treasury 0-1 Year and the FTSE US Treasury Floating-Rate Note Indexes vs indexes tracking longer-dated Treasuries. This reflects the reflation trade as the market focus shifted to economic recovery and inflation risks and long end yields rose sharply.
The impact of both the COVID shock and the reflation trade is also evident in the spikes in volatility at the long end. Chart 2 shows 21-day annualized volatility of longer dated US Treasury indexes reflecting both the pronounced fall in yields after the initial COVID shock in 2020, and the subsequent reversal in yields in 2020/21, as interest rate sentiment deteriorated and the duration effect took hold.
Rising inflation expectations and long duration do not mix well
By contrast, short US Treasuries continue to show much lower volatility, helped by their short duration and in line with historical norms, while delivering modest positive performance. For investors anxious to de-risk in an environment of rising inflation expectations, recent evidence confirms this is a much safer area of the curve to be invested in, rather than pursuing a more aggressive hunt for yield. It is a reminder that long duration and rising inflation expectations do not mix well.
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