Treasury yields signal decline in investor economic exuberance
The recent decline in US Treasury yields reveals some investors’ doubts about the strength of the economy in the coming years, even as inflation hits its highest level in more than a decade.
Yields, which fall when bond prices rise, surprised more than one by slipping in the second quarter of the year. This marks a reversal from the sharp rise in the first three months of the year, when markets generally rode a wave of optimism that the stimulus and reopenings would spur a roaring 1920s-style acceleration.
The yield on the benchmark 10-year US Treasury bond stood at 1.479% on Tuesday, down from 0.913% at the end of last year but down from 1.749% at the end of March.
Treasury yields play an important role in the economy, helping to fix borrowing costs on everything from mortgages to corporate bonds. They are also a closely watched economic barometer, with longer-term yields tending to rise in particular when growth prospects improve and fall when they run out of steam.
Yields on conventional and inflation-protected Treasuries still suggest that the economy will grow at a healthy pace in the years to come. But expectations are not as dynamic as in March. At the time, the yields reflected expectations that the Federal Reserve’s benchmark federal funds rate would stay close to zero this year, but start climbing by 2023 and stabilize at around 2.5%, with no the inflation rate does not fall below the central bank’s 2% target.
Today, investors still expect the Fed to hike rates around the same time, if not a little earlier. But longer-term rate projections have eased somewhat, as have inflation expectations, indicating a slightly weaker economy, less able to withstand interest rate hikes.
Investor economic confidence has been eroded by lower expectations for fiscal and monetary stimulus, some investors and analysts said.
Since the start of the year, many investors have bet that large-scale government spending, near-zero short-term interest rates and continued Fed bond purchases would lift an already shrinking economy. bounce back from the pandemic.
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Expectations peaked recently in March, when Democrats passed a larger-than-expected coronavirus relief bill without a Republican vote, fueling bets that they could have similar success by shifting from other priorities such than infrastructure spending.
Since then, however, progress has been slow, with moderate Democrats insisting on a bipartisan infrastructure bill. Meanwhile, Fed officials have started talks about cutting bond purchases and brought forward the timetable they expect to raise interest rates.
These developments have more than offset the recent increase in inflation. In April and May alone, the consumer price index jumped 1.4%, with basic prices excluding volatile food and energy categories, recording their biggest year-over-year gain in May since 1992. Many investors, however, largely dismissed the gains as outliers of reopening the economy. Fed Chairman Jerome Powell recently pointed out that the recent drop in lumber prices, which were very steep, was a possible sign of things to come.
âThe markets are looking to the future,â said John Bellows, portfolio manager at Western Asset. “Even with high inflation rates, expected inflation has been reassessed down.”
A good number of investors still expect exceptionally strong growth over the next two years and argue that inflation could also remain high, possibly prompting a more aggressive response from the Fed.
In April, economists polled by the Wall Street Journal predicted that the economy, after shrinking 3.5% last year, would grow 6.4% this year and 3.2% in 2022.
In a June report, Jefferies economists Aneta Markowska and Thomas Simons forecast 5% growth next year, in part thanks to the lingering impact of recent stimulus payments that “have left household finances in their best shape. has been training for decades “.
Core inflation is expected to “stay well above 3% until at least April next year,” as consumers continue to spend, economists wrote in another report. Until then, they added, a tight labor market could lead to wage increases, so “any easing of inflationary pressures will likely be transitory.”
Caught off guard by the recent drop in yields, some investors and analysts have blamed idiosyncratic factors such as demand for pensions and foreign central banks.
A popular explanation is that betting on higher returns has become too crowded. âWhen everyone is short and the market is picking up a bit,â hedge funds may be forced to buy bonds to reduce their risk of further losses, said Zhiwei Ren, portfolio manager at Penn Mutual Asset Management . This drops the yields even more.
Still, investors and analysts generally agree that Treasury yields are at least ultimately determined more by economic fundamentals and the outlook for Fed-set interest rates than by technical factors.
âThere is a growing contingent of market participants who are buying into the idea that we have reached peak growth, essentially that the most impressive days of the recovery are behind us,â said Mr. Simons of Jefferies.
His point of view, he said, is that investors have just become too pessimistic and that the 10-year yield could rise to another 2% by the end of the year.
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