The bear steepening of the US Treasury curve has undoubtedly been the story of 2021 so far for fixed income investors, many of whom will have felt the adverse impact of the broad rates sell-off on their portfolios.
With 10-year UST yields having risen above 1.6% for the second time this year, ahead of the March 16-17 FOMC meeting there is plenty of talk about them hitting 2% in 2021, and why and how the Fed might need to respond to the rapid recovery of the US economy that is taking shape. However, none of that talk is coming from the Fed.
In our view, the Fed thinks it is well positioned at the moment and has communicated its plan effectively and consistently. The Fed’s mandate is for full employment and sustainable inflation of 2% with a tolerance level above this target rate; it sees no need for action at this stage.
However, given the pace of recent developments it is easy to see why some market participants are getting twitchy. The passing of a $1.9tr stimulus package, a rapid vaccine rollout and some strong recent data prints have all ramped up expectations for US growth even further, leading longer dated US Treasury rates to price in a lot of good news over a very short timeframe. Given the strong fundamentals we are not surprised to see UST yields at these levels, but we are surprised at the speed with which they have got there.
This speed hasn’t gone unnoticed at the Fed, with officials having expressed concern about the disorderly adjustment in Treasury yields and their dislike for any associated tightening of financial conditions. We would certainly expect the Fed to act should it begin to see evidence of a material tightening.
Another apparent disconnect between the market and the Fed is on jobs. While we saw improvement in the recent non-farm payroll report, the devil is in the detail. The vast majority of jobs created were in the leisure and hospitality sectors, which will naturally be some of the first business segments to benefit as the economy improves and more states begin to open up. It should also be noted that these are generally low paying jobs, which if anything will have lowered the closely-watched average hourly earnings (AHE) numbers. Powell’s main focus thus far has been on restoring the millions of jobs destroyed since the pandemic began, and the Fed has some way to go before reaching anything like full employment; these early boosts may prove to be the lowest hanging fruit.
One area where the market looks to have moved well ahead of what the Fed is communicating is on inflation, with US inflation expectations having ticked up again in recent weeks. The Biden administration’s $1.9tr stimulus package has been a key factor in this, and while it remains to be seen just how much of the stimulus will find its way back into the economy, given the majority has been earmarked for stimulus checks ($465bn) and extended unemployment benefits ($350bn) the economy should receive a substantial boost. For now we don’t expect the stimulus to drastically alter the Fed’s thinking, which is that recent inflationary indicators are transient.
The big unknown here is the vaccine rollout, and how quickly this will translate into economic recovery and growth. Should the Fed’s inflationary and employment targets be reached sooner than expected, then it will certainly need to address these concerns in a timely fashion given its outcome driven approach to forward guidance.
Ultimately we still feel the US will continue to lead the economic recovery ahead of Europe and the UK, which should mean we see a steeper curve for US Treasuries than we do for UK and European government bonds. We think the Fed will stay the course until it sees a major breakthrough in the labor market.
Given the pace of this new economic cycle, and the speed of the somewhat disorderly rise in Treasury yields, it is easy to think either that markets are getting ahead of the Fed, or that the Fed will be too slow to act should action be needed.
From our perspective, the recent uplifts to 2021 US growth forecasts are hard to ignore, and it’s easy to see Treasury yields continuing to creep higher. However, we shouldn’t underestimate the chance of the Fed actually doing something, and given the technical position in Treasuries right now, yields could gap lower if it does. This week’s FOMC meeting and the press conference afterwards might be Powell’s opportunity to at least talk about some action.