Trader watches his screen during the recent bond retreat. (Photo by David Dee Delgado/Getty Images)
Getty ImagesAll of a sudden, it seems, the long placid bond market has lurched into action. Prices have dropped and, as in the way of bond math, yields have risen. The price retreat began late last October and has picked up momentum in this new year. Much of what seems to have upset bond investors has been evident for quite a while. But some sources of concern are relatively new, in particular the spending plans of the Biden administration. The combination of existing and new concerns is hitting markets with what might be described as a four-punch combination.
The accounting to date is far from as devastating as the major bond retreats of the past, but it is noteworthy, nonetheless. Since late last October, the yield on 10-year treasury bonds has risen from 0.8% to 1.4%. The accompanying price erosion has overwhelmed the low yield originally offered on the bonds to give bond buyers a net loss on the investment. Yields on less volatile 5-year treasury notes have risen during this time from 0.4% to 0.75%, also imposing a net loss on the investment. It is not just dollar markets that have seen such action. In Britain, yields on 10-year government bonds have risen from 0.3% to near 0.8%. Australian 10-year government bond yields have risen to about 1.7% from under 0.8% just four months ago. German government bond yields remain negative but have risen some 25 basis points toward positive during this time. All these moves have created losses for bond investors.
Throwing thee first of these four punches was the untenable state of bond markets toward the end of 2020. With short-term interest rates driven down to about zero and actually negative in some places and active bond buying on financial markets by the Federal Reserve (Fed) and other central banks, bond yields had already fallen below the rate of inflation. Without some major policy push to keep driving rates and yields down (and so prices up) bond holding was already a losing proposition in real terms. Meanwhile, the Fed and other central banks showed little likelihood or adding still more support than they already were providing markets. In other words, bonds were an unattractive investment unless the unlikely happened. To be sure, less credit worthy bonds continued to offer yields above the rate of inflation, but the risk they carried recommended other investments above bond buying. In such an environment, anything in the least bit discouraging could tip the flow of monies away from bonds.
The second punch has come out of investors’ understanding that the Fed’s ongoing liquidity support always cut two ways. It sustains demand for financial assets, including bonds, but longer-term and more fundamentally, a surplus of liquidity also always contains the threat of an accelerating inflation that would erode the real value of the interest earned on bonds. While the pandemic raged, investors thought little about inflation, especially since the economy had enjoyed a long stretch of low inflation before the virus arrived, but with vaccinations spreading and a full or almost-full economic re-opening on the horizon, these once faint secondary inflation concerns began to grow in bond investors’ calculations.
To be sure, Fed Chairman Jay Powell assured all and sundry at his recent Congressional testimony that inflation was not a concern. Still, bond investors looked at consensus economic expectations for 4.7% real growth in 2021 and 3.6% in 2022 and could not share Powell’s optimism. They could see that such growth exceeded historic trends in the U.S. economy by a wide margin, implying that the economy would return rapidly to full employment and accordingly develop a potential for economic overheating and inflation problems. The Fed’s clear intention to continue pouring liquidity on the economy in the interim only added to such concerns.
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Concrete evidence of inflationary pressure has thrown a third punch. At the consumer level, inflation does indeed remain quiescent, as Chairman Powell described. The Labor Department’s consumer price index indicates a mere 1.4% general rise in prices during the 12-months ended this past January, the most recent period for which data are available. The broadest price gauge, the deflator for the entire gross domestic product (GDP), also shows little inflation. It has risen a mere 1.2% during the four quarters of 2020. But more sensitive price measures offer less encouragement. Commodity prices have risen sharply during the past six months or so. Copper prices, for example. have jumped some 43% during this time. Other industrial commodities have shown a similar acceleration. Oil prices are up 44%. The latest look at producer prices offered by the Labor Department also offers cause for concern. This gauge of what producers pay for their inputs rose 1.7% during the twelve months, approaching the 2.0% commonly used by policy makers as a preferred target. In January it surged 1.7%, some 22% at an annualized rate. No one expects it to continue at this pace, but the jump is ominous, nonetheless.
The fourth punch, the one most recent, has come out of the deteriorating picture of federal finances. Concerns on this front have grown especially since the election. There can be little doubt that federal finances had taken a bad turn long before November’s vote. Tax cuts in 2017 had already enlarged budget deficits greatly and spending to bolster the economy during the pandemic had added to the flow of red ink, which official sources projected to reach $2.3 trillion in 2021, some 10.3% of GDP and well above historic norms of about 3% of GDP. Then late last year the newly elected President Biden immediately promised an additional $1.9 trillion in spending, bringing the 2021 deficit estimates to over $4 trillion, almost 18% of GDP.
Especially since the economy is expected to surge with the planned re-opening, many economists, even Democratic economists like Larry Somers, have warned that this additional spending is excessive and could lead to economic overheating. The inflation threat is implied. Considering that the new White House is also talking about spending on a version of the Green New Deal, the prospect of over stimulus and an overheated and inflationary economy have become real. If this were not enough to frighten bond investors, the flood tide of red ink implies that tremendous federal borrowing will create a huge supply of new debt and an inevitable downward pressure on bond prices.
Back in the 1990s, bond investors, having suffered great inflation-induced losses during the 1970s and early 1980s, were extremely sensitive to any economic development or government policy that threatened to bring back the inflation hell. On the slightest hint of economic overheating or excessive monetary ease and especially federal budget deficits, bond investors sold out and created sometimes violent market setbacks. The action of what came to be called the “bond vigilantes” disciplined economic policy making. Today’s memories of the damage inflation can cause are neither as recent nor acute enough to recreate the market responses of those times. Nor will the recent rise in yields continue uninterrupted. But recent bond market action is reminiscent of those days of acute sensitivity and worthy of note, by investors and policy makers alike.
The Link LonkMarch 01, 2021 at 08:47PM
https://www.forbes.com/sites/miltonezrati/2021/03/01/bonds-send-a-warning/
Bonds Send A Warning - Forbes
https://news.google.com/search?q=Send&hl=en-US&gl=US&ceid=US:en
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