Treasurys: Signal from Yields
Some market watchers have called the recent moves in Treasurys puzzling — inflation figures published came out higher than anticipated, and indicators on economic recovery were strong. Yet, yields fell. What was the message from fixed income markets?
First, for some basics on bond yield determination. The point at which the demand for, and the supply of, fixed-rate obligations are equalized is determined by two countervailing forces. On the demand side, the buyer seeks compensation to offset the expected loss of purchasing power from inflation. In a growing economy, the individual also wants a portion of the return that is real, i.e., over and above the inflation rate.
The seller of those securities is just as willing to compensate the buyer for the expected inflation because the seller anticipates recouping that portion by the increase in prices of products that he / she would be selling. And when the economy grows, there would also be an increase in the quantity of goods to be sold.
When the interests match, a deal is struck and the equilibrium bond yield is set.
Now, for some recent data. According to the US Bureau of Labor Statistics, the producer price index rose 1% month-on-month in March, and 4.2% since March 2020. This was the highest annual inflation rate since September 2011. Since PPI was weak a year ago, the market was able to consider the annual increase as a statistical artifact, not reflective of a long-term shift. A similar sentiment influenced investor reaction to the pickup in consumer prices, as well. And remember, bond yields are set by expected, rather than historical, inflation. There was no reason yet to believe that the former was significantly affected.
Let us go now to the positive news on the real (i.e., production) front. Industrial production, and its biggest component, manufacturing rose sharply last month. Retail sales rebounded by 9.8% month-on-month in March. Initial jobless claims of 576,000 was a post-covid low. Undoubtedly positive, the bond market wants to know that the strong numbers can be sustained in order for yields to rise. For example, retail sales shot up by 18.3% month-on-month last May before actually dropping by 1.3% in November.
Soothing words from Fed Chairman Jerome Powell and demand for Treasurys from Japanese investors are also credited for the decline in yields. But ultimately, bond yields will be based on expectations for inflation and growth — a key element in my forecasts for Treasury yields over the past four years. A shift in expectations is also why I switched after the January 5 Georgia Senate runoff elections to expect higher yields. Even if the Fed were to maintain a low policy rate, higher inflationary expectations would cause long-dated yields to move up, i.e., the yield curve would steepen.
The combination of continued monetary easing by the Fed, and a climbing federal budget deficit, already 16% of GDP in 2020 according to the Congressional Budget Office, should push up long-term inflationary expectations. Although the economic upturn should continue, do not expect the fast pace so far in 2021 to persist. That was a result of an immense amount of fiscal stimulus put in the hands of consumers over a relatively short period of time. Statistically, even money dropped off from a helicopter would increase the level of GDP in the short-term without necessarily sustaining it.
In conclusion, there is nothing puzzling or counterintuitive about last week’s bond market developments. Investor reaction was rational and followed what economic theory would have suggested. Higher fiscal deficit and persistent sanguinity on the part of the Fed should eventually push up inflation and bond yields.
Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California 90401
April 18, 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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