Investment management consultant MATTHEW FEARGRIEVE explains why yields on government bonds are rising, and why they are set to continue to rise.
No surprises at this week’s meeting of the Federal Open Market Committee (FOMC). The Fed is committed to doing – or, at least, committed to being seen to be doing – everything it takes to support the post-pandemic US economic recovery.
So interest rates are to remain on the floor until at least 2023; and fiscal stimulus (on a massive scale) has been accounted for, factored in, allowances made.
So goes the (intentionally) comforting rhetoric of the Fed. The hike in the Fed’s inflation rate for 2021 will not have gone unnoticed, however. Inflation fears have been spooking the markets for weeks already, and now the Fed has revised its forecast upwards, from 1.8% to 2.4%.
The other big take-away from the FOMC meeting was the Fed’s continuing commitment to purchasing a minimum of US$120 billion of US Treasury bonds and mortgage-backed securities every month.
The yield on US 10-year Treasuries fell on this news. From a level of around 0.9% in December 2020, the 10-year US Treasury yield had risen throughout February to around 1.6%. (This yield is about 2.3% higher than the yield on 10-year Treasury Inflation-Protected Securities, or “TIPS”, compared with a gap of just under 2.0% at the end of last year.) The low rate of December was a sure indication that the markets considered the risk of inflationary erosion on a ten-year debt to be minimal.
So it seems that inflation, if not de facto with us already, may be just around the corner.
The question is when yields on 10-year treasuries will normalise to pre-crisis levels indicated by TIPS (around 2% nominal and 0% real); whether this will happen this year or not. So far this year, nominal yields are up 60bp to 1.54% and real yields are up 40bp to -0.66%. And after the Fed meeting this week, we need to factor in inflation expectations up 22bp to 2.4%.
But as far as yields on government bonds are concerned, the markets have been pricing in inflation for some time. Government stimulus packages and the release of deferred consumer spending post-lockdown are largely at the root of this, and markets have been further spooked by bond vigilantes selling bonds in large amounts, thereby increasing yields.
This, then, is the backdrop to the Fed (and, across the Pond, the European Central Bank) committing to buying more government bonds. An effort to curtail further rises in yields and to avoid, at all costs, a repeat of the 2013 ‘Taper Tantrum’, when the Fed’s decision to reduce its Treasury bond purchasing panicked investors and pushed yields higher.
So: will the Fed’s action be sufficient to reign in the recent rise in yields?
We think not (and we hope we are wrong). We don’t know the detail of the thinking behind the Fed’s decisions, of course, but it could be that their Top Brass considers any whiff of inflation in the air to be purely transitory, an inevitable component of the alluring perfume of economic recovery post-pandemic.
This would be a rational thing to believe: think of the massive (and, the Fed says, necessary) stimulus spending and the hundreds of millions of frustrated consumers soon to hit the malls again – naturally, these circumstances seem set fair to usher in a period of price inflation.
The Fed – we may assume – is banking on any inflationary phase being purely transitory. But what if it is not? What if the inflationary pressure are more persistent and longer-lived?
The vaccine rollout has been a huge boost to the US growth prospects, the US labour market is tightening back up relatively quickly (remember, the Fed has admitted that the jobless rate has become a less reliable inflation signal), supply constraints are still prevalent and there is negligible deleveraging pressure anywhere in US policy or in the US economy.
So the Fed is running the economy “hot”. And whilst it would be rash to think that it will let inflation carry us all away (think of the generous fiscal and monetary policies which in the 60s caused consumer price inflation to leap from under 2% to 5% in the space of a decade) investors should not lose sight of the fact that the mind of the Fed is like the mind of God: unknowable.
So we must remain ignorant of the extent of the Fed’s tolerance of persistent inflationary pressures before it will feel compelled to take normalising action. For the moment, all we have to go on is low interest rates and a verbal commitment to repurchasing US Treasuries.
And we are also ignorant, for the moment, of the longer-term impact of the Fed’s decision this week on bond yields. Before the FOMC meeting, yields on one-to- three year TIPS were depressed in line with rising expectations of inflation and the prospect of Biden’s US$1.9 trillion stimulus package. Simultaneously, medium- and long- term yields were rising.
We think these trends will continue, notwithstanding bond-buying by the Fed (or, for that matter, the ECB in Europe). We know now, after the Fed announcements this week, that:
- growth and inflation expectations have been upgraded;
- the US government is set to issue more debt; and
- the Fed (and, therefore, the Eurozone) is still de facto committed to its 2% inflation limit, notwithstanding the rise in its 2021 inflation forecast to an upper limit of 2.4%.
These dynamics do not dispel the looming prospect of inflation. Nor do they comprehensively discourage the bond vigilantes. We think the markets will continue to fret about a coming inflationary environment. Yields on government bonds have further to climb.
We hope you found this article and the opinions therein informative. To learn more about bonds and bond yields, click here. To learn about the impact of inflation on your personal investments, click here.
MATTHEW FEARGRIEVE is an investment management consultant. You can read his investing blog here and see his Twitter feed here.
IMPORTANT: the views expressed in this article are opinion only, and are not intended to be relied upon as financial advice or treated as a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.