If someone had told you that May’s US annual consumer inflation rate (CPI) would be 5%, you might have expected a bloodbath in the bond markets as investors fled for the exits in anticipation of 1970s-style carnage.
You certainly wouldn’t have expected 10-year Treasury bond yields to fall sharply from 1.75% to 1.5% since April.
The 13-year high in the CPI inflation rate, coupled with rallying Treasurys, has left real yields at -3.5%, a level only seen on a handful of occasions in modern history.
So how can you explain the disconnect between the scary headline inflation data and such low bond yields?
When I was a young fund manager and asked why markets were going up on a particular day, someone would always shout out ‘more buyers than sellers!’
But let’s try to be a little more analytical. Here are 10 reasons why US Treasurys are rallying.
The selloff in Treasurys in the first quarter of this year left yields too cheap and offering good value for the first time in many months. Not only had yields risen, with 30-year bonds up from 1.6% to nearly 2.5%, but the yield curve had steepened too. This resulted in expected 10-year bond yields (known as the 10 year-10 year forward rate) at a generous 3% by 2031, a level which implies a reasonable inflation adjusted yield of +1% (assuming the Fed hits its inflation target over the medium term) – very different to the -3.5% we see now.
2. Lower growth
While we have undoubtedly seen economic data improve in the US since the dark days of March 2020, the markets had come to expect strong numbers. The best of the upward surprises to economic growth are behind us, and since the summer of last year the Citi Economic Surprise Index, a measure of the degree to which economists’ forecast are wrong, has been falling steadily. Indeed in May, the measure turned negative briefly. Data was still generally robust, but bond markets were expecting it to be even stronger. This disappointment meant that bond yields adjusted downwards as rate-hike expectations fell.
3. Transitory inflation
We know that the 5% CPI number is transitory, a word used repeatedly by central bankers to explain that inflation is high today because it was low a year ago. It’s partly about base effects – remember that oil prices briefly went negative in April 2020 – and partly about the reopening rebound, coupled with Covid-related disruptions in the global supply chain. Car prices alone are a big slice of inflation’s rise, but used car prices won’t rise by 10% per month forever, and soon inflation will stabilize. In fact, bond markets recognize that May’s 5% number may well be the peak of the cycle.
4. Lagging wages
The high CPI may itself be the cause of inflation falling again. With this measure now outstripping wage inflation in America, households are seeing their incomes fall in real terms. This means they have less money to spend, and economic growth may weaken as a result. Of course, companies may have to hike salaries to deal with labor shortages, and bond investors need to be alert to a future wage-price spiral, but for the time being inflation has the upper hand.
Talking of labor markets, we’re not out of the woods yet. There are probably 8-10 million Americans yet to return to employment, thanks to furlough schemes and generous unemployment benefits. We’re assuming the economy is running so hot that any unemployment is currently voluntary, but I’m not so sure. On the wider U-6 measure of unemployment, more than 10% of the US workforce can’t get enough work. Things look more like the disinflationary period of the global financial crisis than of a boom.
The Delta variant, also known as the Indian variant, has scared bond investors. Vaccines might be less effective against the variant (or at least the first dose of a two-dose regime) and it’s more transmissible. Full reopenings are being pushed back, hospitalizations are rising, and economic activity will slow once more. The animal spirits we’d hoped for are once again deferred.
7. More buyers than sellers
OK – I’m allowing ‘more buyers than sellers’ on this occasion. US pension funds finally find themselves solvent, with funding ratios (the ratio between their assets and the promises they have made) around 100% in aggregate. Their bet on equities has finally paid off and they want to take their chips off the table and properly offset their pension liabilities with the matching asset of fixed income. With bond yields rising, the last couple of months have been a great time for them to buy government and corporate bonds.
8. Overseas buyers
It’s not just pension funds who have seen the value in US bonds. Overseas investors such as Japanese and European companies have watched Treasurys sell off, while JGBs and bund yields remained at or below zero. Suddenly it became possible to buy American bonds, hedge away the currency risk and end up with a yield much higher than you could get in your domestic currency.
9. More QE
For a while in the first quarter of this year there was speculation that central banks would start to taper quantitative easing (QE) programs in response to strong growth, but there’s no sign of this happening. Every central bank speech reiterates a commitment to keep going with government bond purchases, and for many economies, their central bank is buying back more bonds through QE than are being issued by the government. This is an incredibly powerful technical dynamic for markets.
10. A FAIT better than death
Finally, bond markets are believing what central banks are telling them about their inflation targeting regimes. The Fed calls it Flexible Average Inflation Targeting (FAIT) and it means that they will allow inflation to be above the 2% target for a period to make up for many years of below target inflation. So they will keep official interest rates low for longer, justifying lower long dated bond yields.