The last few days have seen a continuation of the bear steepening trend as US Treasuries have broken out of their recent trading range and marked new cycle highs in yields. 2% on the 30 year briefly provided support but at the second attempt yields comfortably breezed through to finish last night at 2.07%, while the 10 year having bounced off 1.20% very quickly galloped to 1.30%. The short end though remains well anchored as market participants take comfort from the Fed’s current forward guidance of no rate hikes before 2023. A lot will be written and discussed about this move but it does only take us back to yields seen in February last year.
Simultaneously US inflation expectations have also been making an impressive move upwards. The 5 year breakeven rate touched 2.40% yesterday, up from 1.96% at year end. This new level is more significant as inflation expectations have not been this high since 2011 and have spent very little time above 2.50% in the last 20 years.
In our opinion it is not a surprise that either of these moves has occurred but the driver is clearly the latter. We know that starting next month we will be seeing some actual inflation as the base effects of the index start to kick in, but with just under 9 million jobs still to be replaced we put little weight on the numbers coming out in the next few months. However, these data releases will serve as a reminder to investors to consider the slightly longer term inflation expectations which could be more relevant. In our opinion the chances of experiencing the type of inflation that would cause the Fed to act have gone up and should be considered carefully within fixed income positioning. Without writing too much about why, it is worth considering 6 facts:
- H2 is likely to see very strong economic growth
- $1.9 trillion fiscal stimulus will be spent in this period
- Ultra easy monetary policy and QE still in place
- Banks have been lending throughout the pandemic, look at the record growth in M2 in last 12 months, and they will be keen to grow balance sheets further in the fertile conditions of the second half of the year
- Consumers have been saving and are ready to spend (although currently this pent-up demand is conjecture, we wait to see real evidence)
- Higher inflation expectations can become self fulfilling
Will the Fed be worried about this? We don’t think so as things stand, in fact they will probably welcome somewhat higher inflation expectations as it will help them reach their goals. With so many jobs to fill, they are not even thinking about thinking about their monetary policy - but how quickly these jobs are recovered is key to watch. Moves in the labour market tend to lag the cycle and to be slower than other economic figures, but we have to acknowledge that the speed with which some economic variables have moved in this cycle have been unprecedented.
What might worry them right now though is the pace of change of rates markets. Treasury yields gradually going higher is not a bad thing, in fact from a fixed income point of view this is very healthy and will help us position in a more balanced way in the future. However if treasury yields spike higher and keep doing so, then this can be become a tightening of financial conditions and other asset classes can get roped in to the sell off in bond prices. The Fed would not want this.
So far I would say that the move has been reasonably orderly and is likely to remain so, we have just made a new range, but should we end up at the end of this week at 1.40 on the 10 year and next week at 1.50 then its likely that risk sentiment will be affected and markets will elect to book some profits.
For now though, it is what it is, a new range is being established and on good fundamental grounds. Rates are moving higher and credit spreads are moving tighter. This is what is supposed to happen at this stage of the cycle….just not too quickly. However for those who like to worry (me included) everything has moved at such an incredible pace this cycle. Our end of year view on the 10 year is 1.50, but we could get there a lot quicker - now is not the time to be brave on Treasuries.