The first quarter of 2021 was relatively challenging for fixed income investors. There was optimism in the outlook for the underlying economy, but a combination of dovish central bank policy and unprecedented fiscal stimulus resulted in fears of overheating and inflation. In response, rates became a source of risk, as illustrated by the yield on the bellwether 10-year US Treasury finishing Q1 at 1.74%, some 82bp higher than where it started the year.
When rates volatility climbs high enough, it can easily become the main source of risk in other asset classes (such as credit) and cause temporary breakdowns in normal market correlations; this can be a particularly uncomfortable time for taking on credit risk, which is likely what many investors experienced in the challenging first quarter.
Inflation concerns, particularly in the US, remain a key factor in the current market. However, the Fed’s FOMC members have been coordinated in recognising these concerns and have been consistent in arguing that any spike in inflation data will be transitory, and that the Fed has the tools to combat any risk of inflation creating an issue for the long-term economic recovery.
Slowly but surely the wider market appears to be falling in line with the Fed’s assessment, and aided by the higher yields on Treasuries we seem to be finding some stability at current levels. We saw some evidence of this new found stability on April 2 when Non-Farm Payrolls (NFP) showed a massive creation of 916k US jobs during March; this data could have been viewed as highly inflationary, and yet the UST market took it fairly well – the 10-year yield moved 5bp wider before recovering within 48 hours. Treasury stability was tested again on Tuesday as the most widely anticipated CPI data for several years showed month-on-month and year-on-year inflation data had both exceeded expectations, at 0.6% and 2.6% respectively in March. Once again, the move in USTs was fairly muted. The fact that half of the increase in inflation came from petroleum price rises (which are viewed as transitory) played nicely into the Fed’s repeated messaging. It is worth noting that core inflation is slowly moving but it is moderate for now, and a story for another day that the market currently appears willing to overlook.
This highly anticipated inflation data also happened to coincide with this week’s huge UST issuance, coming just hours before a key 30-year auction. A weak seven-year UST auction last month caused a big move wider across the Treasury curve and suggested investors were growing wary of the ongoing Treasury supply mountain. However, Tuesday’s sale of 30-years – a highly inflation sensitive part of the curve – went smoothly with the 30-year yield actually falling a couple of basis points post-auction.
This recent stability in the rates curve suggests to us that for now the market is listening to the Fed’s rhetoric and as a result the UST market feels better balanced. With rates at least temporarily not looking like the source of risk they have been at times this year, this could be a period when adding risk assets feels more comfortable for bond investors.