One of the biggest concerns for investors in the current market environment is the outlook for interest rates. This doesn’t come as a surprise given their insatiable demand for yield, especially among investors who are in or near retirement and on the hunt for adequate and consistent income. The quest for yield has pushed bond yields to near-historic lows across the credit and duration spectrum, and bond investors have enjoyed the long tailwind from falling rates and robust bond fund gains.
Currently, credit spreads among all bond types are at their tightest levels since before the financial crisis, indicating continued strong demand from bond investors across the board. Investor demand has fueled tremendous inflows into bond funds since the end of the financial crisis in 2009. Over this time, around $2.1 trillion has flowed into taxable bond funds. These flows have come at the expense of equity funds, which have seen $1.4 trillion in outflows since 2009 (although an inflow of $1.2 trillion into equity ETFs has offset some of these outflows.)
But how will bond investors react if interest rates reverse course and start to rise, leading to bond fund losses? As of this writing, the 10-year yield is expected to be above 2.0% by next June and the Fed funds futures curve shows a near-60% probability for a Federal Reserve rate hike by the end of 2022. But predicting bond yield is a difficult endeavor. Economists and market analysts regularly miss the target in their estimates, as the chart above illustrates. The black line shows the actual 10-year Treasury yield, while the colored lines represent the consensus of economists’ expectations for where rates are headed over the next six quarters, starting at the beginning of each year. The accuracy in predictions is weak with a clear bias to the upside, given that 11 of the 12 years ultimately had lower rates than predicted. There’s a natural tendency for interest rates to revert to the mean, but after roughly 40 years of falling long-term rates it is impossible to accurately assess what an accurate mean is.
When interest rates shot higher in Q1, we saw some bond market disruption that led to fund outflows, but it was short lived. There’s not much in recent reports that strengthens the case for near-term rate increases. Economic growth and inflation are at multi-decade highs, Treasury and corporate issuance is at record levels, and tapering is on the horizon, yet flows continue into the fixed income space. Growth across the globe is starting to recover, yet there remains nearly $15 trillion in negative yielding debt globally. No economics textbooks can explain this.
The bond market is clearly sending a different picture about the economic environment than the equity market. Stock prices are near record levels, while bond yields have dropped from their recent peak in March and have since hovered in a narrow range. The bond market—both in the current level of interest rates and shape of the yield curve—is pricing in a peak in growth and the potential for a policy error, while equities are embedding optimism. This is not unusual historically; we saw a similar disconnect before the pandemic. However, the bond market isn’t clairvoyant, but it does tend to be more cautious. Closer attention to the future direction of interest rates will show us which market is right.