The yield on the US 10-year Treasury leapt in February and March, accelerating a climb since summer that has seen it rise from 0.6% to 1.7%. US Federal Reserve (Fed) Chair Jerome Powell described the move towards higher yields as a statement of confidence in the economy, yet central banks will be keen to avoid a disorderly re-pricing of rates.
Regime change for inflation?
We will likely get an inflation upswing in coming quarters - the question is whether this is temporary or persistent? The year-on-year base effect from 2020 lows should push it sharply higher, then rapidly fade (see Figure 1). Consumption should act similarly, initially surging on pent-up demand. But inflation is a rate of change index, and this pent-up demand is arguably a one-off. It is harder to argue this is a precursor to a new regime of structurally higher inflation. Despite fiscal and monetary stimulus, unemployment remains high, and the output gap is wide; it will take time to reduce both to the point where they threaten inflation.
Figure 1: Inflation and commodity prices
Source: Bloomberg, Janus Henderson Investors, 1 January 2005 to 1 January 2022, as of 15 March 2021.
Moreover, regional Fed underlying inflation measures are trending weaker.1 This could change, but it reinforces the idea that the Fed has no reason to respond and that inflation would need to move above 2% and stay there to meet their criteria to begin hiking rates under their new average inflation targeting regime.
Figure 2: Fed inflation measures
1Source: Bloomberg, 31 January 2008 to 31 January 2021, as of 15 March 2021.
Are markets too optimistic?
Economists have over-predicted inflation for more than a decade, but this time fiscal and monetary policy are working in tandem. Risk of an inflation ‘surprise' is probably greater in the US due to larger fiscal spend, huge Treasury supply and a higher potential growth rate compared to other developed economies.
Countering this, the fiscal multiplier may be low because excess savings have mostly been accumulated by the top 20% of income earners, who have a lower marginal propensity to consume. The world's developed economies will also exit this recession with substantially higher debt levels than 12 months ago. In already highly indebted economies, the low marginal productivity of this debt has acted as a gravitational pull downwards on government bond yields. Additionally, Chinese credit growth is rolling over, which may suggest a slowdown into 2022, just as fiscal stimulus elsewhere is being reduced.
What could spark disorder?
Central banks have tolerated the rise in long-term bond yields as a sign of improving economic sentiment. But when does a rise go from good news to bad? We believe this has to do with both the pace and the cause. Central banks would be concerned if they saw more disorderly markets (like March 2020). While real yields remain negative, the Fed is likely to remain sanguine, but it will not want to see a repeat of the taper tantrum of 2013 when real yields rose sharply. Higher real rates not only increase costs of debt finance but also affect credit spreads and equity market valuations, which tighten financial conditions. Ultimately, a rise in real yields may end up being self-limiting, if it feeds through to a significant correction in risk assets.
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