The path of the coronavirus should have implications for interest rates, yield curves and credit spreads in 2021 as fixed income markets reflect the evolution of the pandemic.
Short-term interest rates (those with less than three years to maturity), tend to move up or down based on expectations for the future federal funds rate. It is expected that the Federal Reserve intends to keep its overnight rate in the zero to 25 basis point range through the end of 2021 and beyond.
The main driver behind this long-term forward guidance is the Fed’s belief that low policy rates will be needed for some time for the US economy to return to full employment and stable prices. Our team believes that short-term rates should follow Fed rate policy and are likely to stay in today’s tight range for the balance of 2021.
Long-term interest rates (those beyond five years to maturity) tend to be more sensitive to changes in the growth and inflation outlook. Specifically, higher inflation can erode the purchasing power of future interest payments. Investors will typically demand higher yields as compensation when the risk of inflation increases.
Furthermore, the lagged effect of 2020’s monetary and fiscal policy measures, combined with the successful release of an effective COVID-19 vaccine, could set the stage for accelerating GDP and inflation. This, and the massive amount of borrowing required to finance the fiscal stimulus provided in response to the economic shutdown, should lead to potentially higher long-term rates in 2021.
Our outlook for the shape of the yield curve next year is distilled from our view on the behavior of interest rates. The Fed’s new framework for monetary policy suggests that the federal funds rate should remain low for a considerable period to establish inflation expectations near targets for the longer term. Given our views on the direction for interest rates, we believe that the US yield curve is poised to steepen as the gap between short- and long-term rates is likely to continue to increase over the course of 2021.
The Fed has not provided any specific targets for longer-term yields. We believe the Fed will be tolerant of some modest increases in longer-term yields if they remain consistent with continued progress toward the Fed’s price and employment goals. The nomination of Janet Yellen as US Treasury Secretary should act as a positive influence with respect to the Fed’s ability to cooperate with the Treasury on policy programs aimed at satisfying the Fed’s objectives. We think that the Fed will embrace a policy stance that maintains a positively sloped yield curve that a Yellen-led Treasury would also support.
Steepening Yield Curve Suggests the Recovery Should Continue in 2021
10-Year US Treasury Yield Minus 2-Year US Treasury Yield (in Basis Points)
Source: Bloomberg, as of 11/22/2020.
Bond spreads have tightened considerably since the widening that occurred in March and April as the US economy shut down in response to COVID-19. Optimism surrounding the economic reopening partially influenced this move, but the Fed’s emergency credit measures also provided solid support. Our team does not expect a wide repricing of credit in 2021 as happened in early 2020. However, given current valuations, we also see limited opportunity for aggressive spread tightening to take place from today’s levels.
While many of the Fed’s emergency facilities expire at the end of the year, corporate and municipal credit markets seem to have taken the news in stride with confidence in an improving economy and continued monetary and fiscal policy support.
Jeffrey S. MacDonald, Head of Fixed Income Strategies
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