Have markets overreacted to interest-rate fears?

Now is not the time to alter your bond allocation, warn investment experts

Have markets overreacted to interest-rate fears?

As vaccine programmes gather pace and – despite the latest rounds of lockdowns – anticipation grows for economic reopening, virus fears have been replaced by worries around inflation and sooner-than-expected rate hikes.

The Bank of Canada became the first central bank last week to signal a change in policy based on a strong economic rebound. While holding its benchmark rate, it revealed it would pare back its asset purchases, suggested that elevated inflation would return to its 2% target earlier than previously forecast, and raised its growth outlook for the year to 6.5% from 4% in its last quarterly outlook.

Ahead of this week’s Federeal Reserve interest rate announcement, the key questions for investors are: is the selloff warranted, and are rates likely to continue rising significantly from here? Improving economic outlooks are combining to stoke one of fixed income investors’ biggest fears: higher inflation. The selloff has been sharp. After rising more than 7% last year, as of March 29 the Bloomberg Barclays U.S. Aggregate Index was down more than 3% on a year-to-date basis in USD.

Capital Group experts said the answer to both is a resounding no. They believe the market is getting carried away with rate-hike anxiety and that market expectations for a U.S. Federal Reserve rate hike in 2022 are earlier than we anticipate.

Margaret Steinbach, fixed-income investment specialist, explained that this view is based on the Fed’s desire to get the U.S. back to full employment and that on evaluating the labour market, the Fed has articulated a broad approach.

She said: “That means no single employment measure will work as a rate hike trigger. Fed officials will consider a variety of measures of underemployment, labour participation and even employment trends within specific demographic and income groups. Some of those, such as a weak labour participation rate, suggest labour market slack and possibly some longer-term scarring. This should lead to patience on the part of U.S. central bankers when considering when to tighten policy.”

Additionally, she added that the Fed has indicated it is comfortable allowing inflation to run “hot” — above its 2% target — for a period of time if monetary policy is helping to hasten job creation amid elevated unemployment.

“For these reasons, we believe the Fed will remain broadly accommodative,” she said. “It appears likely to encourage strengthening economic activity until late 2023 or even early 2024. Fed Chair Jerome Powell seems committed to projecting any action that could tighten policy well in advance of implementation. We believe the Fed will follow a structured unwinding path. This strategy is likely to be similar to its 2013–2015 signalling that led to its first hike after the financial crisis.”

Capital views shorter-term U.S. Treasuries as attractive at present and that if the market comes around to its view on monetary policy, these yields could decline and associated bond values rise. It is neutral on longer-term Treasuries.

Even if it is wrong and higher rates are rapidly approaching, Steinbach said there are still strong reasons to stay invested in high-quality bonds. She said that rates are rising for a good reason – a strong recovery.

A reason for maintaining bond allocations is that core bonds have shown resilience amid U.S. rate hikes. Typically, bond values decline when rates rise but history suggests this isn’t the whole story.

Ritchie Tuazon, fixed income portfolio manager, said that when rates rise, they historically haven’t done so quickly and sharply enough to cause significant losses over a hiking cycle for core bond investors.

He said: “Recent history is probably more relevant to what we can expect from the Fed as well. When central bankers began raising rates in 2015, they did so gradually. They began with a 25-basis point hike in December 2015. The Fed then waited a full year for another. Over the next year it raised rates three more times, again by just 25-basis points per hike.

“History alone may seem a compelling enough reason not to abandon your core bond allocation when rates begin to rise. However, we would argue a core bond allocation is something a balanced portfolio needs in any market environment. Having a strong core bond allocation can help to provide a measure of stability when unexpected shocks hit. Indeed, today’s market makes an even stronger case for maintaining a solid core.

“With riskier asset prices soaring, we believe investors should prioritize diversification from equities and capital preservation in fixed income. Markets are reflecting the likelihood of a post-pandemic economic upswing, but there could be bumps along the way. As the market crash in early 2020 illustrated, high-quality core fixed income can serve as ballast in portfolios during periods of equity stress.”