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Investment strategy
May 9, 2021
2 mins

When zero is not enough

May 9, 2021
2 mins
David Bailin
Steven Wieting
Electrical engineer installing copper windings into generator stator in electrical engineering

The Fed looks set to keep rates behind inflation, while tightening less than in recent decades. We remain underweight fixed income but increase holdings of less interest-rate sensitive securities such as floating rate bank loans.

  • With help from Friday’s “mere” quarter million job gains, long-term US yields have risen only half as much as they did in the immediate aftermath of the Global Financial Crisis. We believe the largest reason yields have not risen faster is the near-record level of COVID infections globally, despite vaccine success in developed markets.
  • In our view, it is only a matter of time and vaccinations before the global recovery accelerates and we expect bond yields to reflect a substantial change in economic activity.
  • We find ourselves in general disagreement with both sides of the present “consensus” views regarding rates. Specifically, we believe that bond markets are underestimating the coming strength of the economic recovery and overestimating the intermediate rate of inflation. The net effect, in our view, is a potential yield of 2.0% for the 10-year US Treasury by year end, and 2.5% during the coming couple years of expansion.
  • A 2.5% nominal US Treasury yield would only equal the inflation rate of the coming 10 years based on trading data from inflation-linked US bonds. This is unusual as the US has not previously sustained long periods with real yields below zero. We also believe that a 2.5% 10-year is unlikely to hamper the expansion but will continue to challenge valuations of growth equities and speculative investments.
  • We need to position portfolios that can be damaged by zero or negative real yields in the US. The Fed will almost certainly stay true to its promise of lagging behind inflation while tightening less than in recent decades. Therefore, we remain underweight in fixed income, but increase holdings of less interest rate sensitive securities such as floating rate bank loans. We also reduced global small- and mid-cap shares, which tend to outperform only at the start of economic recoveries, but continue to favor global healthcare and its steady growth in sales and profits.  
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