The near-term outlook for the US economy may be bleak, but bond investors see a bright future.
The US Treasury yield curve has steepened to levels not seen since 2016, indicating that investors expect economic expansion and higher inflation in the coming years with the distribution of vaccines against coronavirus and new President Joe Biden and a Democrat-controlled Congress are expected to embrace another substantial stimulus. package.
The steepening of the curve is likely a sign of economic recovery, said Michael Crook, deputy director of investments at Mill Creek Capital. “It is very possible that we are on track for a period of above-trend economic growth unlike anything we have seen in the past two decades, but it will not happen all at once. “
The fly in the ointment could be the Federal Reserve, where regional presidents have started weighing the possibility of cutting the bank’s $ 120 billion in monthly bond purchases if the economy booms later this year. If the Fed stayed on track, the yield curve would likely steepen further, as short-term rates would remain pegged as growth and inflation accelerate.
Nominal Treasury yields have moved “almost to the same level” with inflation-protected Treasury yields over the past week, indicating that the main driver of the rise was growth expectations, Crook said.
Inflation expectations
A steep yield curve – when there is a large spread in interest rates between short-term treasury bills and long-term bonds – often precedes a period of economic expansion, as investors bet that a central bank will be forced to raise rates in the future to curb rising inflation. The reverse is true for inverted yield curves, which suggests that investors see the need for lower interest rates to support slowing inflation.
The 10-year US Treasury yield stood at 1.15% on January 12, up 19 basis points from January 5, when Democrats won races for both Georgia Senate seats and tipped the scales in Congress. The 10-year yield rose 34 basis points in the roughly two months after the US presidential election and is now at its highest level since March 18, 2020, when the beginnings of the coronavirus pandemic triggered strong fluctuations in the bond markets.
10-year T-bill yields are expected to reach 1.5% by the end of 2021 as the coronavirus vaccine rollout, additional government stimulus and overall expectations of an economic recovery push yields on Long bonds on the rise in the first half of this year, Bruno Braizinha, a rate strategist at Bank of America Securities, said in a Jan. 12 note.
The 30-year yield has jumped 32 basis points since November election day, settling at 1.88% on January 12, its highest close since February 21.
Meanwhile, the spread between 5 and 30 year yields climbed to 138 basis points on January 12, its highest point since November 2016. The spread between 2 and 10 year yields closed. at 101 points on January 12. its highest point since May 2017. These spreads remained the same on January 12.
“The skyrocketing indicates that inflation expectations are increasing,” acknowledged Mike O’Rourke, chief market strategist at JonesTrading.
The 10-year break-even rate, a measure of market inflation expectations, stood at 2.06% on January 11, its highest level since November 2018.
Rising inflation expectations, strategists said, will likely only strengthen the Fed’s plan to keep interest rates lower for longer and try to push inflation above 2% to average the years below this target threshold.
“The Fed says it won’t do much until it is convinced that inflation will exceed 2% for a while,” O’Rourke said. “So for now, I don’t expect them to act.”
The Fed’s favorite inflation index, the Basic Personal Consumption Expenditure Price Index, rose 1.4% in November 2020.
Patrick Leary, chief market strategist and senior trader at Incapital, said that in addition to more stimulus, which would be financed by debt, Treasury yields also rise on optimism for a vaccine against coronavirus and the release of pent-up demand later this year. social distancing mandates are relaxed or abandoned altogether.
Feed away from a change
Despite the recent rise, the 10-year yield remains at a historically low level. A return of 1.15% would be unlikely to hurt growth or impact Fed policy, Leary said.
“I don’t think this is necessarily a level that the Fed would consider changing its bond purchases, but rather why yields are rising and the effect of that rise on financial conditions. and more specifically in the stock market, ”Leary said. . “If the stock market hangs in there, I don’t expect the Fed to change from its current pace of bond buying.”
Financial conditions appear to be roughly the same as in mid-February, with the Chicago Fed’s National Financial Conditions Index hitting -0.62. The weekly index measures risk, credit and debt conditions in money markets, debt and equity markets and shadow banking systems. A negative value indicates that the financial conditions are more flexible – borrow and spend more easily – than the average, while a positive value indicates conditions more stringent than the average. The index rose from a recent peak to 0.33 in early April, in large part due to the Fed’s accommodative monetary policies.
The Fed, in order to keep the economic recovery on track, must keep financial conditions loose, said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities. A rise in real rates would signal tightening conditions and could prompt a reaction from the Fed.
“There is no exact column on where the Fed would step in in the market, but we believe it would step in to keep rates from rising excessively,” he said. “If they go up too dramatically in a short period of time and if this increase is motivated by expectations that the Fed is less supportive of the US economy, we think the Fed will signal its dissatisfaction and push back.”
The 10-year real yield, adjusted for expected inflation, stood at -0.93% on January 12, up 15 basis points in one week.
But Goldberg has said he would like to take a 50 basis point increase in real 10-year rates over several months to prompt a rethink of Fed policy.
“The Fed is keen to avoid repeating the Taper Tantrum of 2013, which significantly delayed the recovery by prematurely tightening financial conditions,” he said.
In a Jan. 8 presentation to the Council on Foreign Relations, Richard Clarida, vice chairman of the Fed, said he was “not concerned” about the 10-year rate hike above 1 %.
“The way I look at the bond market and yields is this: you have to try to understand why yields are going up,” Clarida said. “And if yields go up because people are more optimistic about growth, about a vaccine, are more confident, that we can meet our 2% inflation target, then that’s not something that troubles me. in the context of the overview. “
Optimism about 2021 growth has also increased the outlook that the Fed may start slowing the pace of its bond buying program sooner than expected. The Fed buys $ 80 billion in treasury bills and $ 40 billion in mortgage-backed securities each month.
Atlanta Fed Chairman Raphael Bostic told Reuters on Jan.4 that he hoped the central bank could “start recalibrating” the program if the economy rebounded sharply later this year, a sentiment shared by a few other regional Fed chairmen.
For her part, Clarida said her outlook suggests the Fed should keep the program as is throughout the year. Fed Chairman Jerome Powell will also have the opportunity to push back discussions of an early cut during an appearance on Jan. 14 at Princeton University.
Crook with Mill Creek Capital said that despite the potential surge in demand in the second half of this year and the likelihood of another fiscal stimulus from a Democratic Congress, unemployment remains well above full employment, giving the Fed “a lot of leeway” to keep the rate close to zero and its accommodative policy in place.
“I think the mistakes of the last round are important to the Fed, and they will be very careful about restricting the policy before it is absolutely necessary,” Crook said.
