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Message from the Recent Bond Market Turmoil

The late-February spike in U.S. Treasury bond yields sent ripples throughout the global markets. As yields surged to the highest level in a year, stocks and commodities sold off sharply, while the dollar rallied. Some investors called for central banks to step in to calm the markets. The market did eventually settle down without intervention. Ten-year Treasury yields settled at 1.4% after spiking by more than 30 basis points to a peak of 1.6%, the highest level in a year.

Ten-year yields are back to year-ago levels

Source: Bloomberg.  Daily data as of 2/26/2021. Past performance is no guarantee of future results.

 

There were some technical factors that contributed to the sharpness of the move, but nonetheless we believe the bond market is sending an important message: The days of  low volatility are likely behind us. The combination of very easy monetary policy and expansive fiscal policy is shifting the outlook for interest rates higher. With the prospects for economic growth picking up and the Federal Reserve willing to let the economy “run hot” for a period of time, investors are beginning to demand higher yields to compensate for the risk of rising interest rates. The recalibration of yields is likely to be a bumpy process.

Here are three key takeaways from the turmoil:

1. The surge in yields was driven more by prospects for stronger real economic growth than inflation worries.

We can see this by looking at real interest rates—the difference between the change in nominal yields compared to the change in implied inflation expectations. Real 10-year Treasury yields, which had been languishing at -1.0% since last August, have jumped by roughly 40 basis points. About half of that increase came in the past week.

Real 10-year yields are in negative territory

Note: A real interest rate is an interest rate that has been adjusted to remove the effects of inflation.

Source: Bloomberg.  U.S. real 10-year yield (H15X10YR Index). Daily data as of 2/26/2021.

 

With real yields still in negative territory, there is plenty of room for them to normalize longer term if the economy’s prospects continue to improve. Even without rising inflation, yields can continue to rise. While the Federal Reserve may try to temper the move up in bond yields, if it is too fast or appears likely to hinder the economic recovery, the trend is likely to be higher over time.

2. The Fed and the market's views are diverging on timing.

While the Federal Reserve continues to indicate it is planning to keep short-term rates near zero for an extended time period, the market is starting to price in the likelihood that a rate hike will be coming sooner. The Fed’s projections for the interest rate point to no change in policy for two years—until 2023.  Short-term interest rates tend to reflect expectations for the path of the federal funds rate and usually don’t diverge that much from the Fed’s estimates. However, over the past week even two-year yields crept up a bit. More importantly, intermediate-term yields moved up sharply. The move suggests that the market is pricing in the risk that the Federal Reserve will be hiking rates sooner, and perhaps by more than indicated by the Fed’s projections.

The gap between two- and five-year Treasuries has widened

Note: This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 5 year U.S. Treasury Note, then factoring the differences by 100.

Source: Bloomberg. 2 year U.S. Treasury Note and 5 year U.S. Treasury Note Index (USYC2Y5Y Index). Daily data as of 2/26/2021.

 

3. Volatility in the bond market is likely to continue.

We came into the year expecting 10-year Treasury yields to move up to 1.6%. They have already reached that level. For now, we think the market has priced in most of the near-term risks of a stronger economy.

Moreover, the Fed has tools at its disposal to offset the rise in long-term rates. The first step likely would be more communications about why it sees the need to keep rates low. After that, it could buy more long-term bonds, and/or shift some of its purchases of mortgage-backed securities to Treasuries. It could also increase the amount of bonds it is buying.

However, given the improving outlook for the economy coupled with a central bank willing to tolerate higher inflation, we would expect bouts of volatility ahead as markets reprice for a different environment in 2021 and beyond. Over the long run, high yields driven by stronger economic growth are positive, but the process can be volatile. We suggest fixed income investors continue to keep the average duration in their portfolios low and consider strategies like bond ladders that can help manage portfolios in a rising-interest-rate environment.

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see schwab.com/indexdefinitions.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio.  As compared to other fixed income products and strategies, engaging in a bond ladder strategy may potentially result in future reinvestment at lower interest rates and may necessitate higher minimum investments to maintain cost-effectiveness.

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