- Treasury yields are on the rise, with long-term levels approaching levels the CBO currently projects won't happen until 2024.
- Rising yields and the fear of inflation were behind the pummeling of the Nasdaq last week, handing the Composite its biggest percentage loss since last October.
- Will sustained inflation be the result as Covid vaccine supplies gain the upper hand in our quest for herd immunity and we gain some semblance of pre-pandemic economic normalcy?
- The answer is no, and here is why.
Friday’s market close saw the Nasdaq plunge 6.41% from its most recent record close of 14,095 posted on the 12th of February. For the week, the Nasdaq fell a whopping 4.9%, its biggest percentage loss since the week ending 29 October. Stalwart growth positions like Amazon (AMZN), Tesla (TSLA) and Apple (AAPL) that sent the Composite to new heights during the year now bleed red as trading closed in February.
Without question, monetary and fiscal policy initiatives drove stock market to new heights during one of the most tumultuous years this side of the Great Depression. In addition to cutting the federal funds rate to near zero, the Federal Reserve’s balance sheet ballooned to $7.64 trillion through the end of February, up from the distant mid-March total of $4.36 trillion - levels not seen since WWII. On the fiscal side, the CARES Act that passed Congress in March pumped $2.2 trillion directly into the economy. A second round of direct payments to US citizens, about $900 billion in total, cleared Congress in December. And with the change of administrations, a third $1.9 trillion deposit on Covid-19 relief passed the House of Representatives over the weekend - this time on a largely partisan vote. The sum is sure to be reduced in an evenly divided Senate.
Is inflation dam about to break?
The bond market thinks inflation is nigh. Unsurprisingly, the monetary and fiscal responses to date have ignited a protracted, month-long selloff in the bond market. On the long-end of the yield curve, the 10-year Treasury note that started the year at 0.917% closed at 1.415% on Friday - up over 34% for the month and over 54% YTD. The yield on the 30-year Treasury bond forged a similar, though less spectacular path - up almost 16% in February and over 30% YTD. The yield on the 3-year Treasury note is up 73% while the 5-year Treasury note soared 109% YTD. Meanwhile on the short-end of the yield curve, the one-month and three-month Treasury bills have dropped 33% and 49%, respectively, while the yield on the 2-year Treasury note has barely budged over the period, down a mere 3.2% through Friday’s market close.
A steepening yield curve has historically signaled faster economic growth. While the National Bureau of Economic Research (NBER) drew the curtain on the longest expansion of the post-WWII period and the beginning of a pandemic-induced recessionary period in mid-February, it has not yet declared the endpoint of the Covid recession. Congressional Budgetary Office projections have the downturn ending in the 2nd quarter. GDP fell 31.4% in the 2nd quarter, rebounding 33.4% in the 3rd quarter and finishing out the year with a 4.1% GDP spurt in the 4th quarter. At the same time, and with copious help from the Federal Reserve, the S&P 500 soared over 63% after scratching bottom on the 23rd of March.
Many economists do expect an upside trajectory on Treasury yields through the rest of the year due to a variety of outstanding factors. Included in the mix is an increasing supply of Covid-19 vaccines and inoculations as herd immunity comes closer to realization. The so-called reflation trade is a broad signal that the economy will rebound quickly and restore some semblance of pre-pandemic economic normality. Rising confidence could spark higher price inflation in the greater economy. Higher fiscal spending also tends to push bond prices down and yields up by boosting economic growth and with it - price inflation. Higher levels of inflation migrating through the greater economy makes fixed income investments unattractive.
Further pressure on yields come from a recent Treasury decision to reduce its balance sheet cash to around $500 billion from levels that exceeded $1.6 trillion in the heat of the pandemic. The move will flood the market with excess liquidity in the latter part of March, sending yields at the short end of the yield curve further into negative territory while possibly wreaking havoc on the money market space. Banks, meanwhile, may be forced to hold unwanted crates of cash at the Fed which could be more than $5 trillion by early summer.
And on the receiving end, household savings totaled $3.9 trillion in January, up from $1.4 trillion last February. Spending rose 2.4% MOM while personal income shot up 10% in January MOM, mostly a result of fiscal stimulus checks. Disposable income rose 11.4%. Headline PCE, the Fed’s preferred measure of inflation, remained quiescent at 1.5% YOY. Savings were up over 20% during the month from 13.4% in December, pushing the month’s savings to the highest level since May and the highest total since WWII. Expenditures on services, about 70% of the economy, dropped 5.4% YOY.
In dollar terms, real GDP in the greater economy came to $18.8 trillion in the 4th quarter, about 6% below potential, according to CBO projections. The resulting output gap comes to $1.1 trillion, in rough alignment with the Biden administration’s $1.9 trillion package. With more than 75% of the package in the form of direct payments to households, unemployment benefits to furloughed workers and other income support, the fiscal intervention will more likely than bring immediate, though short-term, relief from pandemic-induced disruptions to household balance sheets with minimal multiplier impact to prices in the greater economy. The short-term nature of the latest fiscal intervention is key to keeping inflationary pressures on the intermediate- and long-end of the yield curve at bay.
Another important caveat is the aid package’s reconciliation path to approval by Congress. The reconciliation process has already axed the $15/hour minimum wage proposal passed by the House but excised late last week by the Senate Parliamentarian, leaving progressives scrambling to find a different avenue to raise the federal minimum wage. Friday saw the month-long yield charge lose steam with the 10-year note falling to 1.432% from Thursday’s 1.552% for the first such decline of the month. The breakeven inflation rate, which moves in the opposite direction, rose to -0.71% from Thursday’s -0.60% on the news. More downward movement in yields on the longer-end of the yield curve with upward moves in BE rates could be in the offing as the legislation wends an uncertain path through the Senate.
Breakeven rates do, however, remain curious as shorter BE rates are now higher than longer BE rates. The 10-year BE rate is 2.14% through the end of February, up from 1.54% at the beginning of the year. The real interest rate at the 10-year level, however, remains negative 0.71%. The 30-year BE rate is 2.10% through the end of January, up from 1.79% YOY with the real interest rate just turning positive at 0.03% on the 19th of February for the first time since June. Friday’s market close saw the 30-year BE close at 0.06%. The curiosity comes with the 5-year BE reaching 2.39% - the note’s highest post since April 2011. The real interest rate of the 5-year note, however, remains solidly negative at -1.64%.
Breakeven rates could also influence inflation expectations as TIP yields have risen in February as BE rates have fallen. February’s snapshot could signal weaker growth and a higher likelihood that the Fed will intervene with an uptick of the federal funds rate - or both scenarios simultaneously. Weaker growth in the greater economy and Fed intervention are both highly unlikely. The Fed fund futures project a 4.1% chance of an increase in the funds rate at the forthcoming April, June, September, November and December meetings. At the same time, pandemic lockdowns, stay-at-home mandates, savings rates have all kicked pent-up demand into high gear.
A final note on the deficit. For the first four months of FY2021, the federal budget deficit rose 90% to $738 billion, driven by $142 billion in direct payments to households, $25 billion in rental assistance grants to state and local governments and $34 billion in unemployment benefits. At the beginning of the Great Recession, debt-to-GDP stood at 35%. Fast forward a number of years, the ratio is more than 100%. Importantly, the cost of servicing that debt is significantly lower today than it was in 2007 because real interest rates remain almost universally negative. Interest as a percentage of GDP is under 2%. That gives public policy a good deal of room to maneuver to get the greater economy back on track and people back to work - quickly.
Current projections on personal consumption expenditures (PCE), the preferred measure of the Federal Reserve, projects out at 0.4% in 2020 to 2%, the Fed’s long-term inflation target, by 2024. CBO projections have the yield on the 10-year Treasury note gradually rising to the upside from an average of 0.9% in 2020 to about 1.6% by 2024. Thursday’s yield on the 10-year note hit 1.552% appears unsustainable. Inflation remains firmly anchored for the foreseeable future.
This article was written by
Analyst’s Disclosure: I am/we are long AAPL, TSLA, AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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