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Surge in Rates May Be Overstating the Case for Inflation

Longer-dated Treasury yields have climbed as markets consider whether economic growth and inflation expectations might accelerate more rapidly. We believe inflation pressures will remain in check and bond yields will be range-bound.

U.S. rates have moved substantially higher in the past few weeks, advancing a trend that’s seen Treasury yields rise from historic lows amid the depths of the pandemic last year. As markets try to gauge whether economic growth and inflation could accelerate more quickly than anticipated in 2021, many investors are left wondering whether rates will climb further in the near term. We think upward pressure on inflation is likely to be relatively contained as the global economy continues to recover from the effects of COVID-19, and that yields on longer-dated bonds should stay broadly bounded within recent ranges as central banks keep short-term policy rates anchored near zero.

While there were several catalysts for the bond market sell-off that began in February, which saw 10-year Treasury yields reach the highest levels in about a year, concerns about inflation expectations played a large role. The U.S. yield curve steepened as longer-dated rates rose more than short-dated ones, typically signaling higher expectations for economic expansion and inflation down the road. Although such periodic sharp rate increases can be painful in the short term for bond portfolios, the opportunity for yields to reset higher can offer attractive entry points for active fund managers like PIMCO, and ultimately provide higher income and return potential for investors. Passive funds that track a benchmark may be locked into certain investments even as rates rise, giving active managers with broader, more flexible mandates room to outperform.

The magnitude of fiscal stimulus and accommodative monetary policy in response to the pandemic has positioned 2021 to be a recovery year, alongside vaccine rollouts that should help the U.S. and the world rebound from the negative effects of COVID-19 on economic activity and employment. We are cautiously optimistic on the pace of that recovery (see this January 2021 blog post). We remain alert to the potential implications for price growth, yet we don’t see a substantial risk of a rapid acceleration in inflation, particularly in the near term. There are still several potent forces in place that could curb wage gains and keep inflation in check, even as the Federal Reserve and other central banks maintain low rates and bond-buying programs, and as the U.S. government expands fiscal stimulus spending.

Sustained inflation typically occurs after the economy is operating at full capacity and wage pressures take hold. The pandemic has dented output and demand, while unemployment – though it continues to decline from peak levels early last year – may remain elevated by longer-term standards. Consumer price inflation is likely to climb only moderately this year and could continue to lag behind target levels for the Fed and other central banks. Labor market slack (as discussed in this February 24 blog post) will make wage growth difficult, while factors such as demographic trends and technological innovation are also poised to restrain inflation.

The extent of the bond market sell-off in early 2021 suggests inflation expectations may have run too far, too fast. With a more balanced outlook for inflation, and after the yield curve has steepened significantly in recent months, there may be limitations on how much further yields can climb for now. While it’s certainly possible that rates could still drift somewhat higher, actively managing exposures allows us the ability to build some resiliency and still capitalize on higher yields. With every rise in yields, value is being created for longer-term, income-oriented investors and those looking to diversify a broader asset allocation, particularly with equity valuations near historical highs.

Learn more about PIMCO’s approach to active fixed income management.

Marc Seidner is CIO Non-traditional Strategies.

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Marc P. Seidner

CIO Non-traditional Strategies

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London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

Munich
PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Milan
PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

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