Long-dated US Treasury yields have been falling since early April as markets maintain their trust in Federal Reserve Chairman Jerome Powell’s repeated statements that the inflation pickup is temporary despite the accelerating pace in recent months. But something else happened last week. The 10-year yield plunged to 1.27% on Thursday before rising to close Friday at 1.36%. Such volatility has a lot to say about the state of the world economy, especially regarding growth and inflation.
First, on why yields dropped sharply. Three developments caused investors to shift from optimism on growth prospects to believing that US and global growth has peaked. Covid’s delta variant was increasingly seen as prolonging the health crisis, with a fallout on the economy. OPEC+ showed little sign that two important oil producers, Saudi Arabia and the United Arab Emirates, were close to resolving their differences. Without a production accord, excess demand in world oil markets will persist, pushing up prices and slowing growth. Finally, US initial jobless claims of 373,000 for the latest week were above consensus and rising after two weeks of decline. Perhaps the labor market not recovering is a precursor to global growth slowing?
Yields rose on Friday as bond investors decided that concerns about growth had been exaggerated. However, they still expect inflationary pressures to subside as supply bottlenecks get resolved over time, precluding the need for risk-free yields to increase further. In other words, they buy Powell’s thesis.
There are fallacies in explaining the sharp decline as well as in the subsequent rise in yields. The drop in bond yields was so pronounced because slower growth is believed to cause a reduction in inflationary pressures. This reasoning is erroneous because even though a falloff in aggregate demand could mitigate price pressures, a sustained increase in monetary liquidity will likely aggravate them. Expect the Fed as well as the US Treasury to work together on providing stimulus should overall demand falter.
Return to optimism on growth resulted in Friday’s increase in yields. However, at 1.36%, investors in long-dated obligations will get negative real returns unless inflation also drops from recent levels. I have repeatedly discussed (for example, here) why the upturn in inflation is likely a seminal event rather than a passing phenomenon. The JOLTS report published on Wednesday showed job openings at a record high 9.2 million in May despite a still high unemployment rate, suggesting that the skill mismatch is pushing up wages. This is not likely to go away any time soon.
The coming week is likely to provide further evidence of continuing price pressures. Consumer price numbers on Tuesday, and producer prices being released Wednesday, are key metrics to look for. In particular, watch whether the 6.6% jump in producer prices during the year ending May is starting to translate to inflation at a consumer level.
On the Federal Reserve front, Chair Jerome Powell will give his semi-annual address to Congressional committees on Wednesday and Thursday. He will take questions on how long the central bank expects to continue its easy policy. Expect him to repeat the “inflation is transitory” mantra to justify continuing near-zero interest rates and the $120 billion in monthly bond purchases.
Is there a bridge for sale as well?
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
July 11, 2021
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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Great insights Mr.Kumar!!