Optimism in the economic recovery continues for both Federal Reserve and government officials though they are carefully walking a tightrope of language so as to not be too eager to raise rates too quickly. Secretary Yellen suggested in March that she felt that fiscal and monetary policy could return the labor market to full employment by the end of 2022, and the most recent statement from the FOMC (Federal Open Market Committee) on April 28 mentions that while risks remain, economic and employment have “strengthened.” But, the markets are ever paranoid and remain on tenterhooks with regard to “when when when” the FOMC will step in and either begin to taper or begin to raise rates.
So jumpy are the markets that when Secretary Yellen in an interview with the Atlantic on Tuesday merely mentioned that “(I)t may be that interest rates will have to rise somewhat…” the markets took this as a sign of sooner than later and had a bit of a tantrum. She clarified her comments later adding that she was not providing any specific timing nor suggestion as to rates rising but the market’s swift response illustrates how wary investors are of inflationary forces being anything other than “transient,” as the FOMC continues to emphasize.
Source: ICE BAML, Federal Reserve of Kansas | Past performance is not indicative of future results.
The near immediate additional stimulus from the present administration, the vociferously accomodative stance hammered home by the FOMC during Q1 (the first quarter) and the remarkable increase in COVID-19 vaccinations drove the 10-year U.S. benchmark yield higher by 82.6bps (basis points) to 1.742% in Q1, though the benchmark yield has been hovering around 1.60% in Q2. The 30-year Treasury climbed 76.7bps to 2.413%, the highest it’s been since Q3 2019, though the past few weeks it has pulled back slightly and seems supported around the 2.20% level.
Source: ICE BAML | Past performance is not indicative of future results.
Much of the handwringing and gnashing of teeth about the timing of possible FOMC tapering or rate hikes unfortunately outshines the fact that it is economic optimism that forced a historic selloff in long-duration U.S. Treasuries. It also, unfortunately, highlights the harm in ignoring duration sensitivity in a fixed income portfolio. We continue to feel that spread duration can add value for those who can uncover relative value and accept the additional risk that comes with additional spread, but we believe interest rate duration should be kept well in hand. As we witnessed during the prior quarter, credit management is only part of the battle for fixed income investors.
Recall that measures of inflation are reported on a year-over-year basis, and as a result the months of March through August will likely show inflation growing at a rate that may have previously driven the FOMC to raise rates in response. As the FOMC continues to point out, the inflationary levels we will see during the coming months should be viewed as transitory simply because these measures are reported relative to last year. But going beyond these transitory expectations, FOMC policy and market assumptions converge. Both TIPS (Treasury Inflation-Protected Securities) breakevens and the inflation-swaps market illustrate that real money fixed income investors have digested the FOMC’s “lower for longer” mantra and, therefore, feel inflationary forces will gravitate higher over the next 18-24 months. One must go back to early 2014 to find the inflation swaps market consistently trading at swap fixed rates above 2% for all tenors.
It is longer-run, non-transitory inflation, or more simply, inflation after the economy grows past the dip in economic activity of 2020 which is likely to move the FOMC from the sidelines. To determine what longer-run inflation is expected, we can look to the U.S. Treasury yield curve constructed from the Forward Treasury Market. In general, Treasury markets discount economic expectations and inflationary expectations to determine yields. To illustrate that transitory inflationary pressures are not likely to drive the FOMC from the sidelines, consider the U.S. Forward Treasury Curve above (notably 1-year and 2-year term forwards). Expected levels of inflation are not expected to propel the FOMC to raise rates sooner than 2022 when short-term forwards begin to rise from 7.6bps to 27.6bps between six months and one year from today. With history as our guide, it is important to point out that while we never fight the Fed, the U.S. Forward Treasury market illustrated below does a very good job of discounting expected economic activity than the FOMC dot-plot.
FOMC Policy Guidelines (i.e., the dot-plot) and the U.S. Treasury Forwards Market are often at odds with one another. One need only look back to 2018 when the FOMC made what it has tacitly admitted policy mistakes to see that the forwards market was providing the best guidance as to where rates should be at that time. It is therefore notable that both the forwards market and the FOMC outlook are consistent in their forecast of short-term rates over the next two years. This consistency with the forwards market can provide confidence in the FOMC’s statements that they do not wish to raise rates too soon and repeat the mistakes of 2018 again.
With increasing inflation expectations and improving prospects for growth, we continue to expect that intermediate- to longer-run Treasuries will continue to discount improvement in future activity as they did in Q4 2020 and Q1 2021. The Forward Treasury Curve illustrates that within one year we could see the 10-year benchmark approach 2.00% with the 30-year climbing to nearly 2.50%. While the coming couple of quarters will certainly be remarkable in terms of GDP and inflationary forces, it will become clear during the second half of the year if these forces will begin to manifest beyond the shadow cast by the 2020 pandemic.
While we sometimes draw attention to Gross Private Domestic Investment (GPDI or business investment), the chart below highlights a notable event. During Q1 business investment as a share of GDP rose above 18% for the first time since Q4 2008. While it is anachronistic to draw too many conclusions from this event, improvement in GPDI illustrates that the macro-economic environment, expectations of a domestic economic recovery, and low-cost capital appear to be providing the impetus for business to reinvest domestically. We have decried the dearth of capital investment in this country for several years because business investment is critical for not only improvements in the labor market but in labor productivity as well. While it can temper wage growth in the intermediate term through productivity improvements, business capital investment is critical to the long-term success of an economy.
Given the economic outlook highlighted above, we remain adamant that duration risk must be managed effectively but that relative value can continue to be found with good homework geared toward assets that are pro-cyclical.
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CRN: 2021-0503-9147 R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.