Perspective

Fed vs vigilantes: why bond markets are hotting up


With bond markets centre stage recently, I’ve identified three things to watch in what could be an eventful period to come.

  1. The bond market is in transition. Yields on government and investment grade corporate bonds have shifted higher overall and the market could remain more lively. This makes for a richer active investment environment.
  2. Bank lending is a key indicator of where we are going in the economy. A pick up in lending would likely be a necessary precursor to a more sustained rise in yields.
  3. The Federal Reserve (Fed) versus the bond vigilantes. Will the Fed manage to contain any concerns over inflation or will the vigilantes push yields higher?

What’s been going on in bond markets?

The start of 2021 has been eventful for bond markets. Government yields sped higher as the US stimulus bill fuelled rising growth and inflation expectations. US Treasuries in the intermediate and long-end of the curve, the 10 and 30-year maturities, saw one of the worst quarters on record.

In April, however, yields have snapped back, even as data and inflation has started to pick up. Usually, the opposite would occur. In a measure of these slightly odd goings-on, the 30-year US Treasury yield has fallen lower than the annual rate of consumer price inflation, for only the fifth time since the late-1970s.

US-30-year-yield-below-inflation.png

The recent yield move to some extent reflects a reversion from the very rapid rise in preceding weeks, the pick up in inflation reflects the base effect. That is, the slight “pop” in the inflation rate is largely due to the recovery from the very low level a year ago amid the Covid-19 crisis.

Overall though, it seems to be symptomatic of a transition in markets and the competing forces acting upon it. Fixed income markets have ample scope to be further unsettled in 2021.

Long-term forces keeping yields lower

Most recently, bond yields have started falling, even amid positive data and rising economic optimism. This suggests there are longer-based trends at work, which existed before the pandemic and will continue after. Overall, we will continue to see demographic changes and globalisation keeping yields anchored down. There are few places in the world with embedded, chronic or structural inflation. 

Yields have been moving downward for a long time. There have been periods, as in Q1, where yields have jumped higher. This is going to happen episodically over the next year to 18 months.

It will be especially interesting to see the tussle between the Federal Reserve (Fed) and the bond vigilantes play out. Bond vigilantes are bond investors who take positions at odds with central banks.

This year, while the Fed will be pushing the message that all is calm, inflation is momentary and episodic, the bond vigilantes will be coming guns blazing, talking up the inflation risk and pushing yields up. And, as in Q1, there are going to be scary moments.

Will inflation stick?

The deflationary episode in 2020 means the low comparison to a year ago inevitably leads to a temporary rise in inflation as life begins to normalise.

One thing that is hard to predict is sentiment and what can happen when people believe prices are going to be higher. As we have seen in the past, it starts at the consumer level, with little decisions each day and people bringing forward consumption. We are likely to see little flare ups, being snuffed out by policymakers. 

One thing the market is possibly underappreciating is the Fed’s emerging third mandate – reducing inequality, if you tie that with a stated desire to let inflation run hot, we are potentially going to get to 3%. That is low, but the debt burden, for governments, companies and households, is so heavy that even 3%, or perhaps a bit higher, will be painful.

The fact is, however, the market has just become ever more accustomed to lower for longer rates. This is a decades-long trend and will be very hard to reverse. The only way to do it in the US is increased money supply and the only way to do that is through increased commercial bank lending.

Banking sector

As recent results showed, Wall Street still is continuing to beat Main Street, with investment banking outperforming commercial bank arms. Regulators want this to change and will use policy tools to try to make it happen.  

Demand for loans is not high and banks globally have so much cash they are almost sick with liquidity. It is hard for banks to generate attractive margins on new loans.

Right now there is over $5 trillion on household or consumer balance sheets because people have not been able to spend. The idea is that once you crack open that egg and it spills out into the economy, that leads to inflation. That remains to be seen.

Corporate bond markets is a beneficiary of liquidity and the broader policy backdrop since governments have been disincentivising banks from foreclosing on bad loans. For many months last year bankruptcy courts did not even sit. Defaults as such will likely remain low.

Some of the negative effects of the pandemic have not been processed, leaving banks with a mass of somewhat mouldy assets. This trajectory will continue for longer than expected and to some extent holds banks back from moving on and writing new loans.

Will investors and companies take more risk?

The 30-year yield below CPI is one indication of the transition in markets. This zero or negative real yield will have ramifications. Zero is psychological and will likely push investors to take more risk to get the returns they need.

It is likely that we will see mergers and acquisitions (M&A) increasingly used to boost shareholder value. Credit markets are wide open, there is strong demand and issuance, ratings agencies are flexible and will allow leverage to increase. The low A, high BBB-rated credit markets would be where you would most likely see debt-financed M&A.

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