In the aftermath of the surprise Democrat win in the Georgia Senate run-offs earlier this month, 10-year Treasury yield surged above the 1%-mark. It seemed investors were anticipating a large fiscal stimulus by the incoming Biden administration. But Nick Maroutsos, head of global bonds at Janus Henderson Investors, does not believe rates will go up much further from here.
‘The Blue Wave has moved the goalposts, as Biden will now push for a significant amount of fiscal spending’, notes Maroutsos. ‘But I would caution investors to draw premature conclusions from this new reality. In our view 10-year Treasury rates will stay in check below 1.5%.’
The reason for this is that the Fed is not going to start tapering any time soon. ‘It’s basically the same people running the Fed as in 2007, so the Fed will continue to overpromise and underdeliver. They now say they expect to start hiking rates again in 2023, but I think it will more be like 2025,’ says Maroutsos. The reason for this is simple. ‘The US economy can’t handle higher interest rates. Permanent unemployment is rising, and the lockdowns are probably going to exist much longer than people anticipate. People have been way to optimistic anyway throughout the Covid-crisis,’ notes Maroutsos. ‘This rate rally doesn’t have enough legs, as 2% on 10-year bonds is probably premature given the state of economy,’ he concludes.
Yield curve control
If the Fed stays put, this will also anchor short-term rates close to the current low levels. But this does not necessarily mean that the long end will also stay in check as the economy recovers. For this reason, Maroutsos believes the Fed will at some point ‘inevitably’ resort to some sort of yield curve control, along the lines of the current ECB bond-buying policy. ‘I think they will buy more bonds in the long end to flatten the yield curve if needed.’
The one thing that could put further upward pressure on long-term rates is inflation. Many market watchers believe inflation will rise strongly as the economic recovery picks up pace this year, including Maroutsos’ colleague Simon Ward https://www.investmentofficer.lu/en/news/janus-henderson-inflation-5-2021. But Maroutsos disagrees: ‘The inflationistas are coming out, saying inflation is going to be a huge issue for 2021. But I’m dubious it will stick as there are still a lot of deflationary pressures out there. The Fed has been trying to generate inflation for over a decade and it hasn’t succeeded.’
Inflation around 2%
This doesn’t mean that inflation won’t rise from current low levels though. ‘No doubt we’ll get a bounce-back in prices. People will travel more, spend more. Consumer behaviour will change back to what it was, at least for a while.’ But once the slack of the pandemic has been picked up, inflation will probably fall back to around 2%, the bond strategist believes. This is about the level inflation observed before the pandemic.
And with current low inflation, 10-year Treasuries will have buyers again once yields hit 1.10-1.20%, Maroutsos predicts. ‘There has been a lot of yield starvation going on, so for core bonds these kind of yields look relatively attractive.’ The bond strategist does not believe buyers may be put off by the prospect of US government rising even faster under Biden. ‘There are always going to be buyers of US government debt, and there’s been zero relationship between government bond yields and the level of debt. People are not going to abandon Treasuries.’
Nevertheless, Maroutsos hopes for a gradual return to higher rates. ‘I’m a proponent of higher interest rates because these provide attractive entry points. If we could have a slow grind higher to 1.5% this year, that would be a perfect scenario as the coupon income could offset any losses from higher yields.’
He does not expect default raise to rise much this year as the economy recovers. ‘Credit spreads are tight and I don’t see what would change that. There’s not a lot of appreciation left in credit markets, but at the same time you’ll have a hard time in credit selling off because of the Fed-backing. So overall I’m bullish on credit.’