The Week Ahead – Staying on the Right Tack

Welcome to “The Week Ahead” where we take a moment to provide our thoughts on what we can expect in markets and the economy during the upcoming week.

I am happy to report that recent pandemic trends have been very positive indeed. After the unfortunate run up in infections we saw during and after the holiday season, hospitalization rates have fallen by 20%. While these are short-term trends for now, between the ramping of vaccinations, change in behaviors, and the fact warmer weather will be coming in a few months, there is quite a good chance we have seen the worst of Covid-19. Given the positive data with regard to the virus, a Federal Reserve committed to keeping interest rates extremely low and a Congress that is set to push out a huge amount of ongoing fiscal support, it is difficult to be bearish. However, just as an experienced sailor should never rely on a meteorological forecast while at sea, investors also need to take precautions for stormy weather no matter how calm the water appears.

The domestic bond market has become keenly aware of the potential for a synchronized global economic surge in growth, and has reacted accordingly with steadily rising interest rates. While short-term interest rates are likely to remain at the zero-bound for a couple of years, longer-term 10-year bond yields have risen from the nadir struck on March 8, hitting an all-time low of 0.32% to where they currently are at 1.11%. The Federal Reserve (Fed) is determined to get to its stated goals of 2% average inflation and full employment. Given the potential for rapid growth in the second half of the year, there is a risk inflation goes beyond the 2% target. The question is how the Fed will react to a rising inflationary impulse. If it is perceived as short-lived, then I believe they will stay on hold; however, if it seen as a longer-term trend, they may be forced to accelerate rate hikes. This would almost certainly result in increased market volatility.

Thus far, the pandemic has been a deflationary shock. However, as the economic recovery continues to take hold, higher inflation expectations could shunt 10-year bond yields up to as high as 2% this year. It may not be a bad time to lock in a fixed-rate mortgage. At this point, with low yields and the likelihood that rates continue to drift higher, the bond portion of an investment portfolio is meant to offer stability and liquidity. Much like ballast in a boat, fixed income will help prevent the vessel from capsizing during a maelstrom like the one we saw last March. Bonds, particularly Treasuries, offer tremendous liquidity and diversification advantages unlike any other asset.

This Friday, we will get a look at core inflation. Most economists believe that core inflation for December remained well contained. Inflation probably begins to pick up along with economic growth as the economic recovery continues. Inflation is a complex phenomenon and we have never seen a situation quite like this.

While we remain constructive on risk markets, and are optimistic on both the vaccine rollout and economic re-opening, there is always a chance of an economic squall that derails our thesis. Therefore, having a meaningful amount of high-grade fixed income in portfolios still makes sense for investors with all but the longest time horizons.

Data deck for January 25–January 29: