Was the decline in U.S. Treasury yields this past summer a head fake? Since the last week of September, government note and bond yields have been spiking, with the 10-year vaulting 1.50% while the 30-year crossed back above 2%. Why the about-face?
In a Deep Dive published in July, LCD enumerated financial press speculation regarding reasons behind the spring-into-summer yield decline, including potentially short-term technical factors (excess liquidity seeking a home or investors unwinding steepeners) and longer-lasting fundamental causes ("the economic recovery has peaked," or the delta variant "will do more economic damage than people currently expect").
Now yields are rising. Are they reacting to the crescendo of inflation news? Is it to the potential of diminishing U.S. creditworthiness, given Congress' gamesmanship around raising the national debt ceiling? Is it to the machinations behind the infrastructure and spending bills? Is it to something else?
MORE DEEP DIVES: After great expectations, distressed players broaden 2021 target set
Inflation is certainly a possible perpetrator of the yield rise. It is indisputable that inflation has arrived, at least for now. The 12-month change in the consumer price index, or CPI, has been higher than 5% every month since May. Although the Minneapolis Fed estimates that 2021 will end a tad lower, projecting a 4.8% rise, that would still be the highest annual level since the 5.4% rise in 1990.
The producer price index reflects inflation as well, having risen 0.7% in August from the prior month (after a 1% move in July) and registering an 8.3% jump for the prior 12 months.
Peter Cecchini, director of research and head of macro strategy at Axonic Capital, said we might not even be seeing the worst of it. He noted that current CPI figures may not yet fully reflect the price rises dealt consumers. As an example, he points to the CPI housing cost measure Owners' Equivalent Rent of Primary Residence, which, he notes, has a significant built-in lag, as rents are usually adjusted not more than once per year. Cecchini says the true increase in rental costs might not be visible until as much as six months to a year from now.
Although inflation is here, U.S. Federal Reserve Chairman Jerome Powell has famously been insisting for months that it will not last and will be "transitory." Federal Reserve presidents have been broadcasting that message as well. New York Federal Reserve President John Williams projects inflation will return to about 2% by 2022, while Chicago Fed President Charles Evans goes even further, worrying that the U.S. economy will not generate sufficient inflation in future years, according to reports.
But as Axonic's Cecchini said in the July Deep Dive, in order to be consistent with its mandate to maintain price stability the Fed has to insist that inflation is transitory, as it works to keep inflation expectations at bay. As the established theory goes, if the Fed allowed expectations to rise, eventually so would inflation.
Helping the low-expectations effort, the Fed has kept the definition of "transitory" vague. According to Powell, it is not as concrete as, say, a number of months. Rather, in a July press conference, Powell said it means that price increases "won't go on indefinitely." Inflation would still be transitory if manufacturers are implementing price increases because raw material or labor costs are rising. But inflation would no longer be transitory if "people's expectations about future inflation move up."
The New York Fed's Williams was recently reported saying that inflationary pressures may be with us for another year or so. Fed Chair Powell has said inflation could last into early next year, attributing its continued presence to, among other things, labor, parts and material shortages. That would still mean nearly one year of elevated inflation numbers.
On Oct. 12, Atlanta Fed President Raphael Bostic noted his dissatisfaction with "transitory" as the descriptive word for the current bout of inflation. In a speech to the Peterson Institute for International Economics, he said he prefers "episodic." Citing data from multiple sources, he said, "It is becoming increasingly clear that the feature of this episode that has animated price pressures — mainly the intense and widespread supply chain disruptions — will not be brief." Saying they will last longer than most initially thought, he added, "By this definition, then, the forces are not transitory."
Dan Zwirn, CEO of Arena Investors LP, clearly sees inflation as the dominant culprit causing the new rise in Treasury yields. Referring to the initial late-September move, he says, "The spike is from wildly profligate proposed fiscal policy reinforcing already-embedded inflation expectations." He believes the Fed's first mistake was maintaining low rates and quantitative easing in what he viewed as a healthy market. "We are printing dollar bills faster than value can be created to support them," he says.
Zwirn believes investors are beginning to recognize the potential downside of the extreme level of money creation through both monetary as well as fiscal policy since the first monetary policy reaction to the COVID-19 pandemic. "Markets are starting to grasp the implications of the Biden plan," he says, referring to the president's as-yet-unpassed infrastructure and spending bills.
To Zwirn, one clear result has been the debasement of the U.S. dollar. He also believes that "the Fed has painted itself into a corner" and has failed to create an "environment that appropriately prices risk," by allowing to grow what he says are equity and credit market bubbles. The higher yields, he feels, are reflecting credit market concern.
Taking a different line, Axonic's Cecchini believes that inflation does not have a "first-order impact" on long government yields. Rather, he believes the Fed largely influences longer note and bond yields through its "reaction function, which can take many forms from QE to Fed communication." Only if the Fed is reacting to inflation, is inflation then a driver of long yields.
Cecchini believes that Federal Reserve Chairman Powell's actions show that he has placed the Fed's full-employment mandate ahead of its inflation mandate. Given the Fed's control of longer yields, Cecchini believes "it's not inconsistent to believe inflation will persist while note yields rise less than one might expect given the level of inflation." To that end, he believes the 10-year will not exceed 1.75% this year.
Cecchini believes inflation itself will keep the 10-year yield in check, as inflation will decline either because the Fed, when it is finally ready, will eventually raise short rates to snuff it out, or because the damage inflation causes to earnings will snuff it out. That is, higher costs will drive earnings lower, which in turn will cause equity markets to decline and Treasury yields to hold or even fall in an investor flight to safety. Either way, the Fed's "transitory" inflation prediction will turn out to be true.
Regardless of whether the current move in yields is being driven by inflation, not everyone is worried about it. Scott Schachter, vice president and high-yield strategist at Barclays, believes credit markets are demonstrably healthy even during this period of elevated inflation. He notes that earnings are improving, companies have strong cash balances and interest expense is generally lower than a few years ago given refinancings at lower coupons.
He cautions, however, that we are rapidly approaching the point where "earnings releases matter again," versus the environment until now, where extreme quarter-over-quarter gains were magnified by comparison with pandemic-driven damage.
While constructive on the credit markets, Schachter says those earnings releases could be one place where the market may be vulnerable. "If they don't meet expectations, that's where the problems and risks may lie."
Regarding events in Asia, he noted that while company-specific issues may cause ripples in the U.S. credit markets, he is less concerned than he might be regarding sector-specific news that impacts a swath of companies. He cited Macao-related news as an example, something the markets have seen before.
Arena's Zwirn concurs, saying he doesn't see an "interconnectedness" in any single distressed Asian situation now, as we encountered with Lehman in 2008.