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MACRO RESEARCH
8 April 2021

Higher Volatility Ahead for Fixed Income

The expected improvement in global growth will intensify the debate about the timeline for the removal of monetary accommodation in the Developed Markets’ (DM) rate space. While inflation expectations should continue to increase, there will also be some upward pressure on real yields as markets start to price higher policy rates. Volatility in the DM fixed income space will therefore rise. We continue to forecast higher bond yields and steeper yield curves for all markets.

Market-based inflation expectations are likely to stay elevated

With headwinds from the COVID-pandemic likely to ease over the next few months, we expect the global economy to improve markedly from the second quarter 2021. Financial conditions in the developed markets’ space are very loose and central banks have pledged not to remove monetary accommodation prematurely. Strong fiscal support complements monetary policy in a concerted effort to run the economies hot. We forecast US core CPI to increase to around 3% over the next years. Consequently, we believe that market-based inflation expectations will remain elevated as markets adapt to a higher inflation level. This is the most pertinent in Dollar-based economies (US, Australia, New Zealand, Canada), but we would also expect inflation expectations to increase in the euro area, Switzerland and the UK as the global economy gains traction.
Inflation expectations to remain elevated
inflation_expectations.png
Source: Macrobond, J. Safra Sarasin, 19.02.2021
This is reflected in market-based inflation expectations, which have already recovered strongly from the lows. We believe they will rise further.
Expect some upward pressure on real yields
Real yields are highly correlated with implied policy rates in forward markets. Higher policy rates imply stronger growth ahead, which is usually associated with a required rise in real yields. Similarly, expectations for an eventual ‘tapering’ of central banks’ asset purchases (which have lowered real yields) should lead to upward pressure on real rates.
There is a close relationship between real yields and implied policy rates
yields_policy_rates.png
Source: Bloomberg, J. Safra Sarasin, 19.02.2021
We are convinced that the debate about a removal of monetary accommodation is set to intensify in 2021, in particular in the Dollar markets. Therefore, we expect upward pressure on real yields, but not a ‘taper tantrum’, as in 2013, when the flawed communication with respect to a planned reduction of asset purchases led to a spike in real yields in the US. Unlike 2013, central banks will be more proactive in preparing the markets beforehand. Moreover, they will be slow to acknowledge progress on the inflation front and continue to lean against un-wanted rate hike expectations. Also, given the strongly rising deficits due to fiscal support measures, central banks will find it hard to taper their purchases fast and substantially without risking an unwelcome rise in (real) long-term yields. Nevertheless, there is a risk that a stronger economic rebound and a higher inflation trajectory will force the central banks’ hand earlier than expected. Therefore, we expect volatility in the global fixed income markets to increase significantly in 2021. We expect higher bond yields and steeper curves, in particular in the Dollar markets.
US – strong rebound in Q2 2021
After a relatively soft Q1 2021 resulting from COVID-related restrictions, we expect the US economy to accelerate as the services sector comes progressively back online. The more widespread availability of vaccines will bring substantial relief to the US economy as we move into the second half of 2021. With the introduction of Average Inflation Targeting (AIT), the Fed has explicitly stated that it will not pre-emptively lift interest rates. The year-over-year comparison in the CPI will exhibit jumps due to base effects, with a peak likely in Q2 2021, before drifting back again. We doubt that these fluctuations will convince the Fed to change course. It will likely take a longer stretch of above-target inflation prints to convince the Fed that it has achieved its target. Consequently, we expect the Fed to be slow to recognize progress on the inflation front. Nevertheless, we expect US yields to rise further and the curve to ex-tend its steepening trend. As mentioned earlier, we expect some upward pressure on real yields during the course of 2021 as the market will start to price in higher Fed Funds rates. In fact, implied policy rates have already started to increase from the lows reached last year.
The US yield curve is already steepening
yield_steepening.png
Source: Macrobond, J. Safra Sarasin, 19.02.2021
However, a meaningful premature rise in real yields would lead to a tightening of financial conditions and would be unwelcome at the current stage. The Fed will likely continue to use forward guidance to dampen rate hike expectations and could even shift asset purchases to longer maturities with a particular focus on purchasing TIPS if needed.
Rate expectations have started to rise in the Dollar markets
rate_expectations.png
Source: Bloomberg, J. Safra Sarasin, 19.02.2021
Euro area – policy to remain loose
The European Central Bank (ECB) has not managed to attain its inflation target despite delivering substantial amounts of monetary accommodation for the past 10 years. Therefore, low inflation expectations in the euro area (EA) continue to be firmly entrenched. Nevertheless, market-based inflation expectations have recovered since the lows registered in April 2020, and while they are still significantly below target, we would expect some upside if the euro area economy accelerates as forecast in the second half of 2021.
The message from the last ECB press conference reflected cautious optimism with respect to both growth and inflation in the euro area. In its quest to maintain favourable financing conditions, the ECB had prevented any steepening of the yield curves in the euro area by effectively removing net supply from markets through substantial asset purchases. The reference to the fact that “asset purchase envelopes might not have to be used in full”, is an indication that the ECB could accept some moderate steepening of the yield curves if the euro area economy gains traction in the second half. However, this will not imply changes to forward guidance or a more timely reduction in asset purchases any time soon. The fiscal stimulus measures in the euro area have led to a large increase in public debt for member states and hence large euro area government bond (EGB) issuance, which will require substantial asset purchases, in particular with regard to the euro area peripheral markets. Still, the slight change in tone will likely be enough to lift long-term bond yields moderately through steeper yield curves.
EA yield curves have started to steepen
ea_yieldcurve.png
Source: Macrobond, J. Safra Sarasin, 19.02.2021
UK – optimism by successful vaccine roll-out
The fast and successful roll-out of the COVID vaccine in the UK has led to expectations of an earlier lifting of lockdown measures and hence a swifter rebound in economic growth. While the Bank of England is still considering negative policy rates, they have become less likely now. Consequently, Gilt yields have started to rise and the yield curve has steepened substantially. However, the headwinds from Brexit have not gone away and will continue to haunt the UK economy in the medium to longer term. Still, we expect Gilt yields to rise in 2021 along with the acceleration in global economic growth.
UK yield curve steepening has accelerated
uk_yield.png
Source: Macrobond, J. Safra Sarasin, 19.02.2021

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