The two topics dominating our conversations with fixed income investors at present are US Treasuries (USTs) and inflation, understandable given these were the key risk drivers in a highly eventful and tricky first quarter. Ten-year UST yields ripped higher from just 0.9% at the start of Q1 to almost 1.75% by the end, inflicting losses on most of the world of fixed income. This rates weakness also became the main source of risk in other asset classes, curtailing what might have been a much stronger quarter for returns.
In April, after a lot of nursing from the Fed, Treasuries began to stabilise and ushered in a broader risk rally, but investors are still nervous the rates story will resurface. We would agree.
So what exactly is priced into the market, and where are Treasuries heading next? These are the questions we are now focused on, since we believe getting them right will be key to fixed income returns for the rest of the year.
Only last week I heard one market commentator suggest a reasonable amount of inflation is now priced into Treasury yields. I would strongly disagree with this, which is partly why I am sharing my thoughts on it today. What I see priced in currently is a prolific rebound in economic activity in the second half of 2021 that was just not envisaged late in 2020. The vaccine and its rapid deployment in the US was a game-changer, and in my view this magnitude of growth just wasn’t consistent with yields as low as they were, so yields quickly moved up to compensate. What I also see priced into Treasuries today is the transitory inflation stemming from a 12-month rise in energy prices. The Fed could not have expended more effort trying to explain this. The Fed has also said clearly that it will allow inflation to run a little hot if it comes through, and it will only respond to actual data rather than the data it might expect to see down the line. Finally investors know the Fed will have to taper at some point, but in my view it would rather have more certainty on job creation than try to be too clever around tapering. I believe all this is clearly reflected in today’s yield levels.
What I am pretty clear on is that at 1.6%, 10-year UST yields are not pricing in much of the persistent inflation that would likely push Treasury yields higher and eventually cause the Fed to raise the Fed Funds rate. So in the event we do see this inflation starting to come through, Treasury yields look to have little protection at current levels and the next wave of selling could push yields sharply higher again.
We could write a lot about the risk of inflation and try to talk it up or down, but the evidence is building that the risks are there and the inflation outlook is at least uncertain, and we don’t think uncertain inflation is consistent with current yields either. The sheer pace of this economic recovery is so different to those that have come before and this is putting a lot of pressure on businesses to respond to the new levels of demand. As a result, we are seeing clear price pressures and businesses are not afraid to respond. We speak to all the companies that we invest with about how they are responding to input price pressures, changes in demand or supply chain breakdown, and their ability to move prices accordingly is now a core question for all of them. The upwards price pressure we see today is probably greater than we saw through the whole of the previous cycle, or at the very best, the outlook is uncertain.
Now, when could these inflationary pressures surface in the data? This is really hard to say as businesses have to plan price rises and wage rises and consider how long these input pressures will last. We don’t see the data surprising to the upside in the very near future, and we acknowledge the long term disinflationary forces of the last several years are still working to probably stop it getting out of control, but at some point in early- to mid-2022 we could reasonably expect to see some of this evidence showing up in the numbers.
Crucially while the Fed may wait to see the evidence, markets won’t, and we therefore expect a ‘second wave’ of Treasury selling to happen well before then. We would not be surprised to see the 10-year UST yield break through 2% before this calendar year is out, as a second wave of Treasury selling becomes a feature in the market once again.