Fixed Income Outlook: What’s Next for Fixed Income? Yields, Curves and Spreads Look Beyond Coronavirus

12.15.2020 - Jeffrey S. MacDonald, Head of Fixed Income Strategies

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.

Interest Rate Expectations Heading into the New Year

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.

The Yield Curve Could Continue to Steepen

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.

Credit Spreads Likely to Provide Positive Dynamic for Issuers in 2021

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.

Credit Related Sectors in the Year Ahead
  • Investment grade. Record issuance during 2020 has led to solid liquidity in the corporate market as issuers built up cash levels and refinanced higher coupon debt. Investor demand for yield moving into 2021 should remain supportive for the asset class. We expect supply to moderate in 2021 relative to the past year’s record levels.
  • High yield. Issuers have primarily used 2020 to refinance higher-coupon existing debt. Lower quality issuers, many with high sensitivity to the COVID-19 shutdown, will likely take advantage of liquidity raised this year to maintain operations in advance of a reopened economy later in 2021. Spreads could moderately tighten in an improving economy as fundamentals stabilize and investors continue to actively search for yield.
  • Municipals. Budgetary pressure for the next fiscal year is likely to see some relief from the economic reopening and potential state and local fiscal support in the wake of the November elections. The risk of higher taxes, while lessened by a likely split government, should support demand. Election results at the state and local level may begin to influence policy over the course of 2021 with a divided government mitigating the risk of radical policy changes that earlier expectations of a Blue Wave election result kept elevated.

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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