- The $1.9 trillion fiscal stimulus bill that is being passed by the U.S. Congress will create a new economic environment, one that may cause changes in Federal Reserve policies.
- Over the past decade and especially within the current disrupted environment, the Federal Reserve has been a constant support to the economy and to the stock market.
- The current economic package could result in the Federal Reserve backing off from this support and this would result in investors having to completely change their expectations.
- Just how will investors deal with a situation in which the Federal Reserve is not continually supporting a policy that has aimed to consistently err on the side of monetary ease?
It seems as if the signs are very clear. The passage in the U.S. Congress of the $1.9 trillion economic package of the Biden administration is seen as inflationary as far as the investment community is concerned.
I have been writing about this recently and current market responses, as the bill has gotten closer and closer to passage has just confirmed this viewpoint.
Yesterday, as the bill's passage became more certain, bond yields rose.
Briefly, the yield on the 10-year U.S. Treasury note hit 1.610 percent. This yield has not been this high since January 23, 2020, just before the Federal Reserve began to flood the market with liquidity so as to prevent any further financial market deterioration due to the recognition of the impact of the Covid-19 pandemic and the growing economic recession,
On Tuesday, March 9, however, the yield on this note dropped back to 1.54 percent in the early morning.
Investors are now seeing the highest level this has been in a very long time.
For one, investors seem to be seeing a rise in inflation and this observation is supported by the rise in the inflationary expectations built into the yield on the 10-year U.S. Treasury yield. As of Monday, inflationary expectations for the 10-year horizon now stand a 2.24 percent, consistent with the signals that Federal Reserve officials seem to be sending to the market.
But, investors also seem to be expecting a rise in economic activity due to the passage of the bill. Note that the yield on the 10-year Treasury Inflation Protected Securities (OTCPK:TIPS) also rose to a level it had not seen in quite a while. The yield on the 10-year TIPs rose to a negative 0.64 percent on Monday.
The yield on the TIPs, theoretically, is connected to investor’s expected real rate of growth of the economy. When the yield on TIPs securities rise, faster economic growth is expected.
A Pivotal Shift?
Some analysts are seeing in current events, a pivotal shift in the financial markets in general.
Thushka Maharaj , a multi-asset strategist at JPMorgan Asset Management, argues in the Financial Times,
Markets are undergoing a pivotal shift. Where extraordinary support from central banks was a key driver for markets over the past nine months, economic fundamentals will take the lead this year.”
As the global economy enters a new cycle, new risks are building. The prospect of sustained fiscal stimulus, rising inflation risks and diminished central bank support, collectively challenges the safe harbor that government bonds once provided.”
This gets to a concern that I have been expressing for some time. My latest statement of the issue is found here.
I have explained this (safe harbor effect) over the past several years as a result of the uncertainty going on in the world where “risk-averse” monies from around the globe are seeking out a safe haven and thus large amounts of foreign money have moved into U.S. Treasury securities and this has resulted in “real yields” dropping below zero.”
My argument has been that as long as these “risk-averse” monies remain in the United States, the yield situation in the bond market will stay as it is and has been.”
As things settle down in the world these monies will move back toward their home markets and the yield on these TIPS will begin to rise and move into positive territory.”
This is exactly what Mr. Maharaj is concerned about. He argues that the policy mix in the United States is changing and fiscal policy is becoming more predominant. The Congress is pushing to achieve higher rates of inflation, which imposes a flood on bond yields.
He reasons that
stronger economic growth sparked by unprecedented stimulus or the return of inflation, will eventually lead to a pullback in liquidity support from central banks.”
Investors are not prepared for this type of response. Investors are still betting on the support of the central banks. This attitude has been generated over, at least, the last decade. I have repeatedly written about this situation. The Fed, in its pronouncements, has actually supported this role.
Consequently, Mr. Maharaj is concerned that investors today are not “well hedged” enough concerning this possibility, to combat a possible change. However, he does go on to argue
There currently seems a low likelihood of a sharp hawkish pivot by central banks. But, today, with markets still pricing in significant policy accommodation, even a small recalibration can lead to volatility in bond markets. The doubling of the gap between two-year and 10-year Treasury yields in just a few weeks is a timely reminder of such sensitivity.”
The ultimate reason for this concern is that with the shift in investor’s focus from Fed policy support to economic fundamentals, government bonds cannot provide the safety expected of them. That is, the U.S. could cease to be a safe haven for foreign monies that are risk-averse.
The only way for investors to protect themselves is to diversity internationally. This would, of course, draw lots of money away from the U.S. bond market, and bond prices would decline even further.
The question is, what would this kind of selling of U.S. Treasuries have on U.S. financial markets.
The risk is there, no question about it.
What needs to be done? Well, the Federal Reserve and the U.S. government have spent a long time getting us to where we are today. And, the current situation is one of extreme disequilibrium connected with radical uncertainty. What takes a long time to get into is not easy to reverse.
Hopefully, the Federal Reserve will be able to handle the upcoming disruptions. The investor needs to stay nimble, very nimble.
This article was written by
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