Federal Reserve Board Chair Jerome Powell will announce projections for the economy after the FOMC … [+]
Treasury bond yields surged to a new post-pandemic high last week, extending the bear market that began in August of last year. The 10-year note closed at 1.62% on Friday, up more than 0.70% since the start of the year. There are plenty of reasons for the post-election move higher in interest rates, and a further increase over the next year remains a consensus call from most economists. However, predicting an end to the bear market in bonds is considerably more challenging.
What are the major forces driving yields higher, and when might they abate?
Economic Growth
The most critical driver of the market is the economy. When the economy is expanding, bond yields tend to rise. And right now, the economy is booming. With most Americans likely to have access to a vaccine by May 1, the opening of the service sector is right around the corner. Oxford Economics predicts that the giant fiscal impulse combined with improving health conditions and rapid vaccinations should support 7% GDP growth in 2021, leading to a year-end unemployment rate of 4.6% and core inflation at 2.4%. Above trend GDP growth may be good for the economy, but is negative for bonds.
Fiscal Stimulus
Of course, most of the fiscal impulse will come from Biden’s recently passed 1.9 trillion stimulus measure. The largesse of the plan, which comes just the service sector is about to reopen, has spooked bond investors who fear the boost will lead to higher inflation. With the Biden Administration expected to announce another multi-trillion dollar infrastructure spending program later this year, investors are worried the unprecedented level of government support will be too much for the economy to handle. Additional stimulus is negative for bonds.
Treasury Supply
In addition to fueling inflation expectations, the massive spending-spree will add to the budget deficit, which will need to be financed by government bond issuance. Bond investors are already showing signs of indigestion. Late last month, the Treasury auctioned $62 billion of 7-year notes that tailed 4.2 bp, making it one of the worst auctions in history. With trillions of issuance later this year and without an increase in QE purchases from the Fed, the supply/demand setup for Treasuries looks horrible. Estimates for net issuance in 2021 top $1.8 trillion. The supply picture is negative for bonds.
Inflation
Even before the Covid Relief bill’s passage, the bond market was aggressively pricing in expectations for higher consumer prices. 5-year inflation swap rates have climbed from 1.72% before the election to 2.5% today, above the Fed’s 2% inflation target. Note that the Fed targets core PCE, which generally runs about 0.30% lower than headline CPI inflation on which the swaps are priced. So a breakeven on headline CPI of 2.5% is equivalent to core PCE expectations of 2.2%. Rising commodity prices in everything from oil and gas to scrap steel and tin indicate higher input costs are coming, some of which are likely to get passed through to consumers. Higher inflation expectations are harmful to bonds.
Financial Conditions
In a recent televised interview with the Wall Street Journal, Fed Chairman Powell emphasized that he believes inflation will not be a problem and any spikes will be temporary with no second-round effects. He did not appear concerned about the rise in bond yields unless it led to “persistent tightening in broader financial conditions.” The stock market’s strength has more than offset any tightening in financial conditions coming from higher bond yields. Current conditions are still highly stimulative and are negative for bonds.
Fed Policy
Given the Fed’s zero interest rate policy and the ongoing $120 billion monthly purchases of government bonds and MBS, it is hard to say that the central bank is anything but accommodative. But the accommodation will end eventually, and the bond market knows it. Some expect bond tapering to begin later this year. Powell’s criteria of “substantial further progress” toward its goals may be met sooner than expected.
We could get an early glimpse of changes in the outlook this week when the FOMC will release its latest economic projections and interest rate forecast “dots.” Several large banks, including JP Morgan, predict the median dot for 2023 will show one hike, up from no hikes in the last projection from December.
In the meantime, some bond investors are hoping that the Fed will intervene to arrest the jump in rates. Such an intervention could include another “Operation Twist” whereby the Fed would sell short-dated securities to buy longer-dated bonds. Since Chair Powell just told us that they are not alarmed by what is going on in the bond market, it is hard to believe the Fed will take any additional easing actions at the moment.
Another uncertainty hanging over the market is whether policymakers will extend the rule that expires on March 31 that allows bank holding companies to exclude U.S. Treasuries and deposits held at the Fed from the SLR calculations. If the exemption is not extended, banks could step away from certain balance sheet intensive intermediation activities and remove some support for the market.
Overall, the current Fed policy is bond positive, but near-term changes will likely be negative for bonds.
Positioning
If there is anything positive you can say about the outlook for bonds, it is the widespread consensus view that the only direction bond yields can go is higher. Short positions in futures contracts are at a record, and most economists forecast yields will continue to drift higher. There is a lot of pent-up demand for long-dated Treasuries that will eventually emerge. Many large pension funds with defined benefit obligations, for example, will ultimately reallocate out of equities and into long-dated bonds to defease their liabilities. The average funding ratio has improved over the last quarter thanks to the robust stock market and higher interest rates, so LDI hedging activity is probably not that far off. But pension funds are not dumb. They are aware of the supply picture. With a couple trillion of supply coming over the next year, why rush to buy today?
Yet, not all market participants are negative on bonds. One person who does not buy into the rising-rate narrative is Guggenheim Partners CIO Scott Minerd. He is still bullish on the market and plans to remain that way until the 35-year trend lower in 10-year interest rates is violated, which has not happed yet. He projects the next leg of the bull market could take the 10-year rate as low as -0.5% in 2022.
The fact that most people viewed his prediction as borderline insane goes a long way in telling you the level of conviction held by the bond bears. Looking at the interest rates in Europe, negative rates in the U.S. are not that outlandish an idea. Probable? No. Possible, why not? The negativity toward the bond market right now is, in some ways, quite bond positive.
Time to Buy?
Not yet. Huge net supply, faster than expected economic growth, additional fiscal stimulus, the inflation outlook, and the eventual removal of Fed accommodation will probably keep investors on the sidelines until the fundamental and technical picture for the bond market improves. With 10-year inflation-adjusted yields still at negative 0.65%, it is hard to make the argument that bonds are cheap, even after the latest backup in yields.
