Three Ways Investors Can Capitalize on Election-Driven Rate Volatility

Investors in US fixed-income markets may want to strike while the iron is hot.

In the weeks surrounding the US election, US bond yields climbed sharply, reflecting speculation that President-elect Trump’s policies could lead to higher inflation and a widening federal deficit. The yield on the 10-year US Treasury now stands at 4.4%—80 basis points (bps) above its recent lows in mid-September. Until we have clarity on the tariffs, taxes and other policies of the incoming administration, speculation and rate volatility are likely to persist.

Rather than a setback, we see the uptick in volatility and reversal in yields as an opportunity. Below, we share our thoughts on where yields may go from here, as well as three strategies for capitalizing on today’s environment.

Yield Curve: Under the Influence

Bond yields rose even as the Fed—reacting to incoming data rather than conjecture—continued to ease. As a result, the Treasury yield curve steepened. The yield curve is a snapshot of investors’ current expectations for future economic conditions. Thus, the influences on the short end of the curve differ from those on the long end (Display).

For instance, Fed policy steers the short end of the curve, so investors focus on the latest jobs data and CPI releases. In the intermediate range—from three to 10 years—economic growth is the most important variable. And for the longest maturities, long-term fundamentals matter.

Long-term concerns are also more speculative. Will inflation be structurally higher or lower in the coming decades? How will megatrends such as population growth affect long-term growth? And will US Treasuries remain a risk-free asset?

Today, speculation is particularly high regarding this last question. That’s because some market participants worry that tax cuts might grow the US national debt, which is already roughly 110% of US GDP. The size of that debt and the government’s ability to cover interest expenses on it are significant concerns for the credit-rating agencies.

Fortunately, the US sovereign rating is supported by structural strengths such as high per capita income, the US’s position as the world’s largest economy and a dynamic business environment. The US government also derives tremendous financing flexibility from strong global demand for the US dollar, the world's preeminent reserve currency. We believe these strengths provide a counterbalance to the growing national debt, helping affirm current ratings.

Japan provides evidence that a widening federal deficit does not necessitate higher yields. That country’s debt-to-GDP is nearly twice that of the US, while its yields are much lower. Indeed, since 1990, Japan’s debt-to-GDP has more than quadrupled, even as its 10-year yield fell from over 8% to roughly 1% today.

The bottom line, however, is that the national debt problem is so well known that we believe it’s already priced into the bond market. 

Yields: High for Longer, but Not Forever

When it comes to predicting the direction of bond yields over the near term, visibility is poor. That said, volatility will likely remain elevated. We think yields could continue to trade in a higher range, given market expectations for faster growth and moderately higher inflation. Ten-year Treasury yields may range between 4.25% and 4.75% over the next six months. (It would take meaningfully higher inflation, which we think is unlikely, for yields to rise above 5%.)

But our focus remains on the intermediate term, and we think that’s where investors should focus too. Yields are currently near cyclical peaks; historically, yields have fallen during a Fed easing cycle (Display), and our expectation that the Fed will continue to ease is unchanged. 

Thus, in our view, bonds are likely to enjoy a price boost as yields decline in the coming two to three years. Demand for bonds could be exceptionally strong, given how much money remains on the sidelines seeking an entry point. As of September 30, a record $6.8 trillion was sitting in US money-market funds, a relic of the “T-bill and chill” strategy popular when central banks were aggressively hiking interest rates. Now that the Fed is easing and money-market rates are declining, we anticipate roughly $2.5 to $3 trillion will return to the bond market over the next few years.

Extend Duration—and Other Strategies

We believe investors seeking an entry point into the bond market should take advantage of the recent backup in yields. Those still on the sidelines risk missing out on potential price gains as bond yields decline. Meanwhile, money-market yields closely track Fed actions, so they’re likely to fall too, but with no price bump to compensate.

Investors should next consider these three strategies for capitalizing on current conditions:

1. Extend duration. If your portfolio’s duration, or sensitivity to changes in interest rates, has veered toward the ultrashort side, consider lengthening it. As interest rates decline, duration benefits portfolios by delivering bigger price gains.

Government bonds, the purest source of duration, also provide ample liquidity and help to offset equity market volatility. For instance, in August, Treasuries provided a helpful counterbalance when stock prices fell in response to rising unemployment data. Lastly, because Treasuries are the only sector that has cheapened lately, it makes sense to increase duration through holdings of Treasuries.

But don’t just set your duration and forget it. When yields are higher (and bond prices lower), as they are today, lengthen the duration; when yields are lower (and prices higher), trim your sails. And remember: even if rates do rise further from current levels, high yields provide a cushion against the negative price effect.

2. Put on a “curve steepener.” Where investors position themselves along the yield curve matters too. We see room for further curve steepening as the Fed continues to ease, while longer yields remain elevated due to concerns about the national debt.

We expect the slope between five-year and 30-year bonds to increase most. Historically, when the Fed eased, this part of the curve steepened significantly, driven partly by recessionary environments. This time around, this slope has steepened but is still below historical averages (Display). We expect it to steepen more from here, even if we don’t reach past levels. 

In addition to more generous yield, one benefit of buying bonds at a steep point along the curve is “roll.” When yield curves are upwardly sloping, bonds experience price appreciation as time passes and yields decline—rolling down the curve—as they approach maturity. The steeper the curve, the bigger the price bump.

3. Adopt a balanced stance. We believe that both government bonds and credit sectors have a role to play in portfolios today. Among the most effective strategies are those that pair government bonds with growth-oriented credit assets in a single, dynamically managed portfolio.

This pairing, which takes advantage of the negative correlation between government bonds and growth assets, also helps mitigate risks outside our base-case scenario of moderate growth—such as the return of extreme inflation or an economic collapse.

In addition, combining diversifying assets in a single portfolio makes it easier to manage the interplay of rate and credit risks and to readily tilt toward duration or credit according to market conditions.

Finding the Silver Lining in Volatility

We think investors should get comfortable with evolving policy expectations and short-term turbulence, while keeping their eyes on broader trends, such as moderate economic growth and high yield levels. As we see it, today’s conditions are favorable for investors who seize the moment.