Strange bond moves could signal slower growth in H2
“If we found ourselves in a slightly higher interest rate environment, it would indeed be a plus for the point of view of the company and that of the Fed,” said Janet Yellen, who has a little more knowledge than transient of the subject.
“We’ve been battling too low inflation and too low interest rates for a decade now,” the Treasury Secretary and former Federal Reserve chief said in an interview with Bloomberg last week. Yet despite the kind of monetary and fiscal expansion hitherto confined to wartime, government policies only seem capable of raising inflation.
Consumer inflation is now at an annual rate of 5%, the fastest pace since mid-2008, and barely too low by anyone’s standards. Fed policymakers are calling the current increase “transient,” a phenomenon that will fade away once the effects of measuring price levels depressed by last year’s pandemic have ended and bottlenecks are over. ‘supply bottleneck will be gone. Others see price trends as less benign. Deutsche Bank warns that “neglecting inflation leaves global economies sitting on a time bomb.”
If alarms are ringing, they should be stronger in the bond market. Yet precisely the opposite is happening. After the release of consumer price data on Thursday, the benchmark 10-year T-bill yield fell to 1.43%, its lowest level since early March, and sharply lower from its recent high 1.745% at the end of the month. Lower yields translate into higher bond prices, contrary to what one would expect, given the steady rise in inflation and signs of economic recovery.
Either way, the continued decline in bond yields had a salutary effect on equities. The S&P 500 Index closed at a record high Thursday, supported by tech stocks with valuations inflated by falling long-term interest rates. At the same time, the Cboe volatility index, a.k.a. the VIX, has fallen to around 16, a quiet reading not seen since that distant time before Covid-19.
In the midst of such optimism (or complacency), the question remains: why would a rational investor buy bonds that yield much less than the rate of inflation? Even the 30-year Treasury, which traded at 2.13% on Thursday night, drew strong demand when it was auctioned that day, even though it is below the implied inflation rate of 2.35% over the next decade derived from the Inflation-protected Treasury securities market.
There have also been huge purchases of high quality corporate bonds, even though they offer an almost record spread over T-bills. A somewhat less obvious reason for this is that corporate pension plans have become relatively flourishing, in part because of the record stock market (which increases the value of their assets) and the earlier rise in interest rates ( which reduces the net present value of their future liabilities). Private pension plans were 98.8% funded at the end of May, down from 98.4% in April and a recent low of 82% last July, according to Bank of America.
Corporations can transfer retirement assets into an annuity from an insurance company. This effectively rids them of headaches caused by balance sheet volatility or slowing profits resulting from pension accounting, according to a report by the bank’s credit strategy team, led by Hans Mikkelsen. This is a major activity for insurers, who buy bonds to finance the annuities they purchase.
These technical factors aside, the fundamentals of accelerating inflation seem to outweigh everything else. This is, after all, the predictable result of the Fed’s balance sheet nearly doubling in size from before the pandemic, to $ 7.9 trillion, and a budget deficit on track to surpass the record 3 Trillion dollars from last year. And recently, the bond market seemed to follow this scenario, as the 10-year Treasury yield fell from just under 1% at the end of 2020 to almost 1.75%. But instead of continuing at 2%, as most forecasters and market participants had expected, the benchmark yield slipped below 1.50%.
The dreaded David Rosenberg suggests that all the “bad news” for bonds – huge fiscal and monetary juice, double-digit economic growth, reports of widespread wage increases, as well as expectations for infrastructure spending additional and reopening as vaccinations spread – are already factored in. the market.
“What is not in the price is a relapse in economic growth in the second half of the year,” writes the director of Rosenberg Research. “Does anyone see the 8% drop in auto sales in May?” ”
Likewise, A. Gary Shilling, who also runs a consulting firm named after him, writes in a letter to a client that the real estate bubble, while nowhere near as inflated as during the unrest, is starting to deflate. In April, sales of existing homes fell for the third consecutive month, while new housing starts fell 9.5%. In addition, building permits are on the decline. (What Rosie and Gary also have in common is that Merrill Lynch showed them the door decades ago for less than optimistic, but prescient, predictions.)
The confusing message from recent bond action could be that now too apparent inflation was not factored into the sharp rise in yields in the first quarter. The subsequent drop in yields suggests slower growth to come in the second half of the year and beyond. That declining yields are a global phenomenon implies that these economic effects extend beyond the United States.
Or, given Yellen’s stated endorsement of higher inflation and interest rates, this could be another example of a government half-done mission.
Write to Randall W. Forsyth at [email protected]