A report published last Thursday examined prospects for fixed-income markets in 2021. Extremely accommodative monetary conditions and the likelihood that the global economy will strengthen as vaccines are rolled out are setting the stage for upward pressure on bond yields. We are underweight government bonds and remain short duration; favoring corporate debt, inflation-linked bonds, and EM sovereign debt (U.S. dollar-denominated and local-currency). Our preferred absolute return play for 2021 is EM local-currency debt.
Looking ahead to late-2021 and beyond, one risk factor that is not on many investors’ radar, is the possibility of inflation gradually picking up. The report noted that after a brief deflation scare this spring, conditions have stabilized without the lingering deflationary pressures that existed in the 2010s after the Great Recession. A slow-moving inflation uptrend eventually took hold late last decade, primarily within the U.S., which caused a sustained rise in Treasury yields and forced the Fed into a tightening cycle.
Already, long-term inflation expectations are climbing in both the U.S. and the euro area, providing a very early warning sign that current depressed policy rates and bond yields are ultimately unsustainable. Stay tuned.