Inflation takes centre stage: Rising US yields point to shifting market expectations
By Adithya Puravankara, Thomas Geller, Zhenxiang Lu, Mouneil Sethi, LSESU Trading Society
US 10-year treasury yields have hit a year high of 1.364%, nearing pre-pandemic levels. The rise in long term rates reflects changing market sentiments following the US election and optimism surrounding the vaccine rollout. Investors have raised their long-term inflation expectations in light of Biden's $1.9 trillion stimulus plan, signalling from the Fed that they will tolerate higher inflation in the short term to allow the economy to recover fully. Recent efficacy reports from Israel show that vaccines are having a material impact on reducing the spread of Covid and preventing 98.6% of deaths (for the Pfizer jab). Positive news on the vaccine front signals a path out of the crisis and the beginning of a strong recovery backed by pent-up consumer demand and government stimulus. The increased expectations for inflation and possible Fed action nearer than previously expected have been felt by the longer maturity bond market, with a significant sell-off beginning last Friday. Ramifications on other parts of the market are beginning to be felt, with a tapering of equity markets that have been sky high in light of a low-interest-rate environment. This report will look at inflation expectations more closely and how we believe this story will playout for the rest of the fixed income market and the broader economy.
One of the most significant sticking points in the debate over US President Joe Biden's $1.9 trillion stimulus package is the prospect of runaway inflation. The 10-year breakeven inflation rate – a measure of expected average inflation over the next 10 years derived from Treasury securities – has risen to its highest level since 2014, at 2.14%:
Real yields on Treasuries (i.e. accounted for inflation) have been dragged higher from a record low of -1.12% on the first trading day of the year to -0.8% at the time of writing. This is because inflation erodes the real value of bond coupon payments, making them decreasingly attractive stores of value, prompting a sell-off. Proponents of lower stimulus, including Larry Summers, argue that if untamed, government spending of this magnitude could 'set off inflationary pressures of a kind we have not seen in a generation' with dire consequences for the value of the dollar and financial market stability. If these fears do materialise, the Fed's dovish stance on monetary policy and the difficulties in mobilising congressional support for austerity measures could make inflation all the more difficult to contain.
The basis of inflationary worries lies in the fact that excessive stimulus might double up with an already expected unleashing of consumer expenditure. JP Morgan estimates that the household saving rate almost doubled last year to 12.9%, which could translate into a potential $1.5 trillion of pent-up consumer demand as the pandemic subsides. Furthermore, wage and salary incomes are now at about $30 billion a month below pre-covid-19 forecasts, while stimulus measures are expected to put this figure at $150 billion above estimates. These factors converge at the overarching theme of how large the so-called 'output gap' truly is. Simultaneously, those vying for lower levels of stimulus claim the output gap is too low to justify spending at these levels. Many on Wall Street argue otherwise.
Goldman Sachs' economists, for example, argue that the real size of the output gap is more than twice the size of the Congressional Budget Office's estimates, pointing to errors in their model and thus maintaining that 'inflation risk remains limited'. Bank of America's analysis followed a similar tone, noting that markets were painting a much more positive picture of the economy and that 'the hole in the economy' still needed addressing before concerns about high inflation are entertained.
The steepening curve of US Treasury Yields is likely a sign of economic recovery. There are three main contributors which will impact the potential future trend for US Treasury Yields. Firstly, the vaccine rollout in the US and globally is likely to have the most significant influence. As economies start to reopen and social distancing measures are relaxed or dropped entirely, treasury yields will continue to rise on the optimism the pandemic is ending. In addition, President Biden's $1.9 trillion stimulus package was advanced out of the House Budget Committee on Monday 22nd February and has now passed. The bill will proceed to the Senate, which may see some alterations, but is the final step until the bill is introduced in full motion. This will likely support many investors' optimism for 2021 and boost US treasury yields even further. A potential limiting factor to the growth of the yield curve could be the Federal Reserve, where regional presidents have begun weighing the possibility of reducing the bank's $120 billion in monthly bond purchases. These could number $80 billion in Treasuries and $40 billion in mortgage-backed securities if there is an economic boom later this year. Should the Fed stay on course, the yield curve would likely steepen further as short-term rates remain pegged as growth and inflation accelerate. However, looking into the long term, optimism about 2021 growth means the Fed may start to pull back the pace of its bond purchase program earlier than expected.
Impact on the economy and other FI instruments
It is important to note that while higher real rates indicate that growth is gaining traction, investors are becoming uneasy about the sustainability of future growth prospects, especially due to the rise in borrowing costs. According to Peter Chatwell, a strategist at Mizuho International, The 5-year note leading the rout "is a warning signal that the rates sell-off is going beyond a repricing towards a convexity move, this is something which we think is inconsistent with Fed dovish rhetoric on rates." The bond slump has forced sellers in the $7 trillion Dollar mortgage-backed market to either unload long-term treasury bonds or adjust derivative positions to compensate for the unexpected jump in their mortgage portfolios' duration. The yields on the 2- and 5-year bonds continue to be influenced by the starting point and speed of normalisation in the economy, which, as mentioned before, is looking good so far. With five-year yields taking flight, some investors appeared to get squeezed out of bets on a steeper yield curve, which has been a winner for weeks amid the global reflation trade. The spread between 5- and 30-year rates collapsed by roughly 15 basis points, the most since March.
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