It better be transitory

Like many, our fixed-income team is scratching its collective head over the behavior of long yields. A 10-year Treasury that fell 27 basis points in the second quarter doesn’t really fit with an economy growing at its fastest pace in 40 years, core inflation that’s rising the most in a decade (this morning’s year-over-year core CPI print for June was near a 30-year high) and a fiscal backdrop that’s racking up record trillion-dollar-plus deficits. Yes, Federal Reserve policymakers surprised somewhat in mid-June, projecting the first policy rate increases as early as late 2022/early 2023, if the dot plot is to be believed. But the bulk of Q2’s decline in longer yields already had occurred before that June 16 revelation. And honestly, policy hikes off zero-bound that are still two years out are hardly restrictive.

So, what’s behind the confounding conduct of long bond rates? My colleagues and I can think of a litany of potential rationales: We’ve already reached peak/transitory inflation and the hullaballoo over rising prices is overdone (arguably Chair Powell’s base case). We’re at peak growth (although an economy moderating off near double-digit growth is still unusually strong). Having benefited from record stock prices, pensions are rebalancing into bonds. Relative to low and negative rates in much of the world, U.S. Treasuries remain attractive to non-U.S. investors. And investors positioned for rates to rise, not fall—the vast consensus trade—are being forced to unwind positions. Virtually all the above would suggest another leg up in yields awaits, a view our teams believe will prove to be the case.

Sticking with rising-rate positioning and credit overweights

In our model portfolios, we are maintaining duration well short of benchmark and positioning for a steepening yield curve, albeit at a more moderate pace than where we stood in Q2. After significant Q1 contributions when long Treasuries sold off, the two rate-driven factors were a modest drag on alpha in the spring quarter. But with yields so low, the absolute impact was minimal relative to both the potential contribution had long yields moved up in Q2 as we thought they would—and still do heading into third quarter—as well as the aforementioned positive contributions in Q1. The good news is our overweights to credit sectors, notably emerging markets, high yield and investment-grade corporates, more than offset our negative rate factors, making for another quarter of competitive performance relative to benchmarks for our fixed-income strategies. We are largely keeping those overweights in place. While we don’t envision much additional appreciation with rate spreads relative to comparable Treasuries so tight, coupon rates remain attractive on a relative basis.

It’s all about inflation expectations

There is a darker explanation for Q2’s decline in longer yields—one we believe is unlikely but nonetheless keeps us up at night. It centers on the argument Q1’s sell-off was the inflection point, and that’s all we’re going to get for a while. The premise would be the market sniffed out higher and stickier inflation than the Fed thinks will be the case and made its move, knowing policymakers will have to step in earlier and harder. That would require inflation expectations that have become so deeply embedded after decades of disinflation to shift up abruptly and sustainably. Not to the double-digit levels of the late 1970s/early 1980s, necessarily. But a move to even 3%, 4% or 5% would force significant Fed reaction—and a re-pricing of the bond market and all risk assets for that matter.

We’re not saying this is likely, only that it’s not worth dismissing entirely. As fixed-income managers, we are paid to worry about the “unknown unknowns,’’ as the late U.S. Defense Secretary Donald Rumsfeld might have called them. In conference calls, our analysts aren’t hearing much evidence of such a shift in inflation psychology, even if they have noticed shifts in actual “cost inflation.” They say companies are trying to hold the line on prices by cutting shifts or hours, putting off purchases or substituting capital for labor. They don’t want to be “Amazoned.” If this disinflationary mindset turns significantly—and remember, part of the Fed’s goal is to lift it off the sub-2% floor where it’s languished for a decade—then it would be time to start worrying. We aren’t there yet and hopefully won’t ever get there. In other words, inflation better be transitory.