US Treasury yields are divorced from macroeconomic fundamentals. Where they go from here will depend largely on the way that the Fed exits from its ultra-loose monetary policy over the next few years.
News that US headline inflation had increased at an annual rate of 5% in May seems to have bypassed the bond market. In particular, the yield on benchmark 10-year US Treasuries dipped to a three-month low of 1.43% in mid-June, just days after the announcement. What’s more, it’s been falling since March, when it pushed comfortably beyond 1.7%.
This downward yield trajectory for 10-year Treasury notes is taking hold against a backdrop of strong economic growth and rising inflation. Trying to make sense of these numbers — and what they reveal about the functioning of the Treasury market and the path of US fiscal and monetary policy — has become an urgent task as the world’s largest economy emerges from the Covid-19 pandemic.
When I look at the bond market, in a sense it worries me, but it also impresses me how resilient it has been
In some ways, it seems that the US Treasury market has divorced itself from key macroeconomic fundamentals. In normal circumstances, bond yields typically rise as inflation expectations increase. But in the US, headline and core inflation has been growing for some time and is even outpacing economists’ expectations.
“US consumer price inflation (CPI) exceeded consensus estimates for the third month straight, with year-on-year CPI coming in hot at 5% for the month of May. Although a large print was expected, given the lower CPI base figure from depressed levels in May 2020, a 5% figure with a 3.8% core inflation print is hard to ignore,” says Ali Jaffari, head of North American capital markets at Validus Risk Management.
Mixed data
But investors in US Treasuries seem to be doing just that: ignoring it. This could be happening for a number of reasons, but chief among them appears to be the country’s relatively “noisy” official economic data, according to research from the Institute of International Finance (IIF).
Put simply, despite the rise in headline and core inflation investors are looking at other sources of data and buying into the Federal Reserve’s narrative that the recent spike in inflation is transitory. “I think the number one explanation at the moment is just that expectations were pretty high for a strong rebound but the data is kind of mixed. [When it comes to inflation] of course there are different indicators [to consider], but, in the end, it’s payrolls that really matter,” says Robin Brooks, chief economist at the IIF.
Lacklustre labour market figures from April, in which just 278,000 jobs were created, were followed by an improved figure of 559,000 in May, although this was still below economists’ expectations of 650,000. And, in light of the Fed’s emphasis on generating jobs and lifting marginalised communities into full employment, it appears that the market is placing greater emphasis on these numbers than ever before. “The Fed has laid out a framework where they are very focused on getting employment back to pre-Covid levels, so the importance of payrolls in the mind of the market has gone way up,” says Mr Brooks.
Even so, it is still unclear whether to label bond traders as deeply foolish or impressively astute, given the fundamentals of the current macroeconomic landscape. As research from BofA Securities makes clear, there are plenty of reasons to believe that higher persistent inflation is coming. For one, a number of secondary indicators are flashing red, including the National Federation of Independent Business survey showing that consumers are being hit by rising price pressures, while rent prices also seem to be on the uptick.
Report authors Ethan S Harris and Alex Lin note: “Digging around in the business press, a growing list of excuses are being offered for the shortages and signs of inflation. There is some truth to all of these arguments, but it is implausible to argue that all of the recent inflation problems are temporary. Most importantly, these ‘temporary’ pressures will probably persist for many months and could become embedded in inflation psychology. This is particularly likely, given that monetary and fiscal authorities have demonstrated in word and action that they want a red-hot economy and rising inflation in the next few years.”
Strong demand for Treasuries
In any case, demand for US Treasury securities remains high despite this inflationary backdrop. Beyond the actions of the Fed, which continues to hoover up $80bn of Treasuries a month, interest in the market remains broad, a factor that is also helping to push yields lower.
“There is really strong demand for Treasuries; it’s been a theme for certainly the past few quarters. This demand is persistent and it’s pervasive. The interesting thing about it is that it starts off with the Fed, then you have the US pension funds continuing to build up their holdings of fixed income, and then there is global interest too. [All of this] is keeping rates abnormally low,” says Padhraic Garvey, regional head of research, Americas, at ING.
The interplay between inflation — either transitory or persistent — and the demand for US Treasuries exposure will be one of the great unknowns of the next few years. “[The US Treasury market] is pretty much divorced from where the macro story is, in the sense that [the economy’s experiencing] a spurt of economic growth and inflation. Clearly the nominal treasury yield is well below where inflation is and there’s a big debate about where inflation is going to go,” says Mr Garvey.
What is certain for now is that the Fed’s quantitative easing programme, which includes buying Treasuries on both the short and long end of the yield curve, has generated vast amounts of liquidity in the financial system. This liquidity has consequently artificially propped up asset prices — the most notable example being US equities, which hit all-time highs in early 2021 even as the Covid-19 pandemic continued around the world.
So much liquidity has been created by the Fed’s interventions that record amounts of cash have been offloaded into the Fed’s reverse repo window in recent times. In early June, this figure hit $503bn, marking a third successive record intake for the facility.
“It’s basically cash that is earmarked to go into safe money market-type products that just has to go into the Fed because if it goes anywhere else, it’s going to be a negative yielding outcome. It’s an illustration of the excess liquidity in the system. What this excess liquidity is doing, from a pure market perspective, is creating a really artificial set of circumstances that’s been absolutely dictated by Fed policy,” says Mr Garvey.
Widening deficits
The extent of Fed asset purchases is all the more pertinent in light of the growing dominance of fiscal policy in the US. President Joe Biden’s administration has responded to the Covid-19 pandemic with overwhelming fiscal firepower, and continues to push for further spending packages to revamp the economy. This approach is likely to widen US fiscal deficits for longer, while expanding an already-high public debt position over the coming years.
As Keith Wade, chief economist at Schroders, argues, this could lead to a situation in which the Fed, which already holds more than one fifth of the Treasury market on its balance sheet, has to continue to support fiscal policy to suppress borrowing costs while simultaneously trying to fend off inflation.
There’s lots of discussion about fiscal dominance and the idea that the Fed can’t be hawkish
“There’s lots of discussion about fiscal dominance and the idea that the Fed can’t be hawkish because it’s going to push Treasury yields too high. These are open questions,” says Mr Brooks.
This is just one consideration among many when it comes to the outlook for the Fed’s policy actions. During the latest Federal Open Market Committee meeting, which took place on June 15 and 16, the Federal Reserve began informal discussions about winding down its asset purchase programme but noted more data was required before any forward guidance was offered.
Looking ahead, the Fed will have to tread a careful line when the time comes to taper. On the one hand, its support for the US Treasury market, as well as the market’s buy-in to the Fed’s narrative over inflation, has calmed investor sentiment. And although the Fed plans to offer plenty of notice around any decision to taper, it still runs the risk of spooking the market. The last time this happened was in 2013 during the so-called “taper tantrum”, which saw a big sell off in Treasury debt.
Tapering schedule
Meanwhile, officials signalled that two interest rate rises were likely in 2023, bringing forward earlier estimates of a rate hike occurring in 2024. Treasury yields climbed in response to this move, with the yield on the 10 year note reaching 1.57% on Wednesday June 16, up from 1.51% on the previous day but still well below the highs registered in the early months of the year. This relatively muted response, if anything, underscores the market’s continued belief that the Fed has it right on inflation.
As officials at the central bank pursue full employment, with an emphasis on marginalised groups, coupled with the adoption of “outcome based” forward guidance, there is every chance that they are acting in a manner that is strategically astute. But two key hazards lie on the road ahead. The first is that the Fed is misreading the signals coming out of the economy, with inflation proving to be a persistent and growing problem.
The other is that its massive quantitative easing programme has distorted financial markets to the extent that an eventual move to taper asset purchases will generate market turmoil.
Whatever happens, the performance of the US Treasury market will be crucial. Where yields go from here will reveal a lot about the trajectory of the national economy, as well as the longer-term implications for fiscal and monetary policy. A health check of the market today offers reasons to be both optimistic and concerned. For one, yields are low and stable, even though inflation is on the increase. Yet this in itself is also unusual and a glance at the yield on the five-year note, which was just below 0.8% in mid-June, underlines some of the distortions in the market.
“I will say that when I look at the bond market, in a sense it worries me, but it also impresses me how resilient it has been to this inflation scare that we’re seeing being played out in front of our eyes,” says ING’s Mr Garvey.
Over the next 12 to 18 months, some of the big question marks hanging over the US Treasury market are likely to be answered. Until then, it will be a case of waiting to see if the Fed has got it right.
