The US Federal Reserve (Fed) has been overwhelmed by the scale and persistence of inflation. The central bank also sees some continuing strength in the real economy – and a shortage of people to do the jobs. The long shadow of Covid hangs over the labour market, with people of all ages missing from action, still not returning to the workforce following the pandemic.
Some seem to have taken early retirement. Some younger people have taken more courses. Some in the middle years have shifted their work-life balance more away from work. A Fed which a year ago was focused on jobs, growth and the need to back activity is now preoccupied with an inflation that worries both parties in Congress. Plus, a President whose unpopularity ahead of the mid-term elections in November is part-linked to soaring prices.
The threat of more rate rises to come, coupled with expectations of a policy to reduce the size of the Fed balance sheet, in due course, by selling bonds has spooked the bond markets. The ten-year US Treasury yield is now at 2.5%, well up on the 1.7% recorded as recently as March 1, and on the low of 0.5% in the summer of 2020. The two-year Treasury is at 2.38% compared to its Covid low of around 0.1%. The thirty-year bond offers a yield today of 2.6% compared to just under 1% at the 2020 low.
Chart 1: Treasury yield curves
Bond experts point out that this is a very flat curve – you get little extra yield for lending for thirty years rather than two years. This implies inflation will subside, as clearly owning a bond yielding just 2.6% when inflation is raging at 7% or more means large real losses. It also implies that two-year rates will eventually come down from 2.38%, otherwise why lock into the longer-dated instrument and take the extra risk?
Some in the bond market seem to think the central bank and Biden administration will do enough to squeeze inflation out of the system at the price of slowing activity. Many participants think the inflation itself will help bring on the slowdown, as people will be short of cash for discretionary items as the cost of rent, food, heating and travel bills go through the roof.
The real economy figures for the US imply that the long and sustained period of money creation and bond buying, which only ended this month, has greatly boosted output and jobs, so it will take time for things to subside. The Fed cannot be sure they will do so and needs to keep an eye open for any signs of inflation embedding through a surge in wages. Should that happen there would be another sell-off in bonds – and the need for higher rates for longer to end the price rises.
There is a further negative influence. A persistent large fiscal deficit, allied to some wish to trim the Fed balance sheet, means a continuing supply of around $2 trillion of Treasury bonds for the markets to absorb in the year ahead.
Europe joins in the sell-off
In the Euro area, bonds too have seen a sell off. This is despite the European Central Bank (ECB) continuing a substantial programme of money creation and bond buying and making reassuring noises about the need to sustain the prices of Italian and Greek bonds as well as of the core German, French and Dutch ones.
The German ten-year bund now rests with a yield of 0.6%, a big advance on the minus 0.71% at the low during the pandemic lockdowns. The thirty-year bond offers 0.68%, well up on a slightly negative yield at the low. The two-year is currently on minus 0.08%. This yield curve reflects the fact that markets do not expect a rate rise in the Euro area any time soon and can still rely on ECB support for a bit longer.
Whilst the ECB has hinted at removing special support by the middle of this year, the impact of the war in Ukraine on confidence and activity may delay moves to end bond buying by the authorities. The ECB may decide to live with more inflation for longer despite the Bundesbank’s disapproval. They are likely to be keen to keep the Italian economy well supplied with cheap money ahead of important elections where the Eurosceptic parties have some strength in the polls.
Chart 2: Euro Area yield curves for AAA rated issuers
The latest purchasing managers indices (PMIs), which are surveys from selected companies providing a summary of general business and economic conditions in the private sector, have been strong but the outlook is clouding.. Confidence surveys provide a reasonable picture too. However, they reflect the continuing support shown by the ECB and Fed so far. They also do not yet capture the full effects on family and business budgets of the latest surge in oil and gas prices, especially in Europe, and the impact of the Russian war on supply chains and other prices.
It is a bit early for bond markets to be signalling recession, as they still have not done much to rein in inflation. It will take time for the hits to real incomes to slow economies enough to release the inflationary pressures. In the meantime, bond markets need to deal with substantial issuance and the ending of bond buying in the US by the Fed, coupled with slowing bond buying in Europe. Bond markets are likely to continue to worry about the large gap between the yields on offer and the current levels of inflation.
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