Bonds Commentary
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Inflation, Taper Talk Take Center Stage Into Summer

May 2021

U.S. Treasury yields presented traders with ample opportunities to make money from either the long or short side throughout April, while offering up little in the way of opportunities for long-term investors to reposition and shorten the duration of their fixed income portfolio, should they so desire. The U.S. 10-year Treasury yield, after ending January, February, and March at a higher level than where it began each month, broke that trend in April, closing the month down 9 basis points at 1.65%. The closely watched 10-year yield has been stuck in a trading range between 1.55% and 1.74% since the start of March and traders, including short-term tactical traders, are likely to continue to key off of those levels until further notice, selling long bonds when the 10-year approaches 1.74% and buying them back around 1.55%. As March wrapped up, the 10-year yield appeared to be on a collision course with the 2% level, but auction results in mid-April were encouraging and indicated robust demand for long-term Treasuries from abroad, stopping the upward climb of long-term yields in its tracks.

While a period of range-bound, relative calm in the Treasury market is most welcome as it has given investors a chance to catch their breath after rates rose in unsettling fashion in January and February, we don’t expect it to last much longer. Inflation is the topic du jour with prices of commodities as well as intermediate and finished goods rising along with labor costs over recent months. With inflationary pressures building, chatter has grown louder that perhaps the Federal Open Market Committee (FOMC) could pivot to a less accommodative stance, potentially announcing a reduction, i.e. taper of its $120 billion per month in bond purchases sooner than market participants had previously thought.

The market received mixed messages from FOMC Chair Jerome Powell and Treasury Secretary Janet Yellen as May began. Chair Powell and other FOMC members have, for the most part, been speaking from the same script and have tried to alleviate investor concerns that a taper would be required over the near-term to combat inflation. Secretary Yellen, however, made comments that appeared to be somewhat at odds with the FOMC’s ‘steady as she goes’ stance regarding bond purchases, although she did attempt to walk back her comments in short order, which led to a sigh of relief and some buying in long dated Treasuries. A tapering ‘test drive’ for markets could come at the Kansas City Federal Reserve’s annual Jackson Hole symposium in August, an event that has historically been a popular venue for such announcements. Fixed income investors and traders aren’t likely to wait for Jackson Hole to reallocate and position for such an announcement, and the 10-year Treasury yield almost doubling from 1.63% to 3.00% in four months’ time during the Taper Tantrum of 2013 will likely be top-of-mind. As Mr. Market often reminds us, however, history may rhyme, but it rarely repeats.

While talk of a taper and inflation could dominate conversations surrounding fixed income allocations into the summer months, our recommended positioning to combat what we see materializing is unchanged. We continue to believe that the path of least resistance for long-term Treasury yields is higher through year-end but making a sizable duration bet is fraught with potential missteps and unforeseen consequences for investors. While we continue to recommend a duration profile below that of our benchmark to reduce interest rate sensitivity, we don’t want to be too short as the reduced yield or carry is difficult to replace without taking on significant credit risk. Shorter duration corporate bonds, both investment grade and high yield, are a relatively appealing place to be as taper talk grows louder, inflationary pressures build, and the global economy recovers. We remain underweight Treasuries, but should rates rise sharply due to some combination of taper, faster economic growth, and/or rising inflation, we would expect our portfolio duration to extend to take advantage of higher yields available farther out on the curve, but a more defensive posture remains warranted at present in our view.

Source: Bloomberg, Factset

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