Treasury yields have been trending downward since May 2021 despite higher-than-expected inflation reading of 5% YoY and 0.6% MoM in May 2021, followed by a 0.9% sequential rise in June 2021, the largest one-month rise since the 1% increase in 2008.
Yields rose rapidly since the start of 2021 as vaccination picked up in the US and the prospects of reopening implied higher inflation in the future, forcing the Fed to raise rates. However, the yield on the 10-year treasury has dropped 40bps since May as the Fed allayed fears of higher inflation, calling the current surge “transitory” and not looking to raise rates before 2023. Also, the Delta variant is on the rise in the US with over 50,000 daily cases since the third week of July. This has pushed back the full reopening of the economy and has driven an increase in the unemployment rate to 5.9% in June, compared to 5.8% in the previous month, which remains considerably higher compared to pre-covid levels of 3.5%.
10-year US Treasury Yield and 30-year US Treasury Yields (%)
CPI outpacing PPI considerably – is this indicative of economic strength?
From the beginning of the year till mid-March, monthly PPI increase outpaced CPI considerably by 20-90 bps. This could reflect manufacturers’ hesitation in passing on higher prices given the relatively weaker economic conditions in Q1 as lockdown restrictions remained albeit the vaccination rate was picking up. For the subsequent two months, the two rose in tandem but since the beginning of June, CPI has been much higher than PPI, underscoring the manufacturer’s ability to pass on higher inflation, perhaps easing the margin compression witnessed in the Q1. Is this sign of a much healthier economy? And does it mean that even if transitory, the current inflation may persist for a while?
Consumer Price Index, Producers Price Index, and Core CPI- 1 month % change (2021)
Source: U.S Bureau of Statistics
Inflation-transitory or here to stay for the long term?
The Fed expects inflation to be higher than their target rate of 2% in the near term to reflect transitory factors as the economy re-opens with increased vaccine role outs, which will push up the “pent-up” demand. US households are sitting at over USD2.5 trillion of excess savings, bolstered by the relief package provided by the Fed. As the economy continues to re-open, some of this excess saving will drive up consumer demand and prices. Because the supply of most commodities cannot be increased immediately to meet this temporary surge, the Fed believes that this recent increase in inflation will taper down to the Fed’s long-term level in the long run.
The Central Bank’s policies through the pandemic and the Federal government’s multitrillion-dollar pandemic relief package provided the people with the incentive to stay at home. It provided the largest relief packages in US history of $2.3 trillion, which included a one-time payment of $1,200 per person plus $500 per child and expansion of unemployment benefits. In December 2020, US Congress passed another $900bn stimulus and relief bill which added another $600 of direct payments and such payments were available for people making up to $75,000 per year. Post elections, President Joe Biden’s Department of Education announced the extension of federally held student loan forgiveness to 30th September 2021 which was set to expire on 31st January 2021.
In addition, the Federal Reserve cut its federal fund rate twice by 0.5% and 1%, which brought down the rate in the range of 0.00% to 0.25%, and cut its discount rate by 1.5% to bring it down to 0.25%. The Fed also conducted an asset repurchasing program wherein, it repurchased $982Bn worth of mortgage bonds since March 2020 to improve liquidity in the markets along with announcing several lending programs for businesses. The Federal Reserve continued to hold its benchmark rate to its target near 0% to 0.25%.
However optimistic the Fed may be, there is still a lingering possibility that the inflation may not be transitory. The delta variant is up to 5-6 times more transmissible than the original Wuhan virus, against which vaccinations have proven to be less successful. But the vaccinations have significantly brought down the fatality rate. For instance, while daily new cases in the US have reached about 60,000 in July, daily deaths have hovered around 300, implying a fatality rate of just 0.5%.In the UK, the fatality rate is even lower at ~0.2% Thus, there is a strong possibility that the economy may not shut down, in the same manner, this time leading to a continued surge in demand and prices.
The path to rate increases is not straightforward
The US Fed has bought $982Bn worth of mortgages since 5th March 2020 and owns up to 32% of the total market for the securities with plans to keep buying $40 bn of mortgage-backed securities every month. These purchases, along with the Fed’s purchase of $80 bn of Treasury debt each month is aimed at controlling long-term borrowing costs to protect the economy as it recovers from the ongoing pandemic and to improve employment.
Fed’s presence in the mortgaged-backed securities market has led to an increase in purchase prices for the buyer as higher prices lead to increasing in borrowings and additional leverage. The Federal Reserve officials signaled in their meeting in mid-June that they expect to raise interest rates by late 2023. They expect to lift the benchmark by 0.6% by end of 2023.
Following its announcement on June 16th, The Federal Reserve on Wednesday, 28th July 2021 announced that it will continue with its $120Bn per month debt purchase until “substantial further progress” is made towards maximum employment and price stability goals. The Fed officials are also wary of their 2013 “taper tantrum” fiasco and are discussing when and how to reduce asset purchases as they begin to reduce the support provided to the economy.
Moving forward, rather than a surprise turn in monetary policy like in 2013, the Fed will be cautious and will take enough precautions. This can be seen evidently as after the announcement in mid-June, bond yields fell further and stock volatility diminished as investors were unresponsive. The Federal Reserve is expected to reduce the pace of its asset purchases to begin the tapering process to reduce its support.
Shrinking corporate debt spreads as investors hunt for yield
The ICE BofA US High yield index, a commonly used benchmark for junk bonds has fallen 17% from its high of 3.78% in January 2021 to 3.26% in July 2021. The shrinking spreads reflected the investors’ willingness to take on more risk and earn higher returns. In the last month, as the delta variant cases surged in the US, spreads have slightly widened highlighting rising wariness about the impact of the virus on the economy, the reopening trend, and on corporates. So the OAS corporate index rose from 0.89% in June 2021 to 0.92% in July 2021 while the High Yield index rose to 3.26% in July 2021 to 3.17% in June 2021.
ICE BofA US Corporate Index OAS (%) and ICE BofA US High Yield Index OAS (%)
Source: Fred Economic Data