US Yields – Policy Error?
US Yields – Policy Error?
In recent weeks there has been a definite cooling in the economic outlook. Economic surprise indices have started to persistently disappoint and governments have started to withdraw some of the exceptional policy support to incomes. Consequently, inflation expectations have started to roll over. In the US, the recent (albeit extremely modest) tightening of the Federal Reserve’s guidance coupled with the scaling back of President Joe Biden’s stimulus plans has led some to question the sustainability of the recovery. Where this has been seen most acutely is in fixed income markets.
Back in mid-June, when the Fed first made its slightly hawkish tilt the yield curve flattened aggressively. If we look at the spread between 5-year and 30-year yields, we can see that it fell significantly around this time; that is, long term yields fell relative to short term yields. This is the market effectively saying “OK, you’re more likely to raise rates in the short term, but this isn’t going to work out well and in the impact of this will be slower economic growth prospects and hence rates further out will need to be lower”. In short, this is the market screaming “policy error!” from the top of its voice.
The second major action in fixed income markets came more recently, when there was a downward shift in the whole curve. For example, US 10-year yields fell from around 1.5% to around 1.3% in the first few days of July. Again, this is the market saying, that the inflation we are currently experiencing is indeed transitory and is already starting to roll over. All this leads us to two important and obviously related questions. Firstly, is raising rates a policy error? Secondly, is inflation transitory?
To address these in turn: Firstly, would raising rates be a policy error? Given the starting point of government debt to GDP of 130% and the US running massive twin deficits, any attempt to meaningfully raise rates would very quickly crash US equity markets and with it the US economy, settling off a debt spiral as tax receipts collapse and government transfer payments explode higher. While US bonds might benefit in the very short-term from a flight to “quality”, very soon with the writing on the wall, the US Treasury market would likely become “dysfunctional” with not enough buyers to meet the overwhelming issuance. At this point the Fed would have to step in and we would be back to square one, at best. In short, raising rates before debt to GDP levels have been meaningfully reduced is likely to be a massive mistake. Does the Fed know this? It strains credulity to think they do not. As such, we view the recent change in tone as nothing more than a tactic to take some short-term heat out of commodity and property prices by hinting at something long into the future, that when it comes down to it, is unlikely to materialise.
As to whether inflation is transitory, we must consider the long-term supply and demand dynamics and importantly the effect of policy on them. Given what we have seen in response to the pandemic where governments have stepped in to support demand and the banking system has come through relatively unscathed, it is hard to envisage a situation where demand is allowed to fall away. The supply side is trickier with travel restrictions still in place, capital spending significantly curtailed and governments shifting priorities from supply chain efficiency to supply chain robustness. This would all point towards a more inflationary bias in the years ahead than we have experienced in the last decade.
However, as always, the most important things to consider are incentives. The only way to restore sustainability to the current precarious situation is for the economy to grow in nominal terms faster than the debt. That can be through real growth or inflation and while governments cannot guarantee the former, they can certainly guarantee the latter. To the extent that the moves in fixed income markets in recent weeks are a signal that policy is not loose enough to facilitate these ends, expect it to be reversed in due course.
US 30-year - 5-year Yield Spread
US 10-year Yield