BlueBay AM: If the Fed is really surprised at lower yields, why is it buying so many bonds?

6 augustus 2021

By Mark Dowding, CIO at BlueBay Asset Management

US Treasury yields continued their recent decline through the first part of the past week, until firm economic data and comments from the US Federal Reserve’s (Fed) Richard Clarida prompted something of a reversal.

US Treasury yields continued their recent decline through the first part of the past week, until firm economic data and comments from the US Federal Reserve’s (Fed) Richard Clarida prompted something of a reversal.

Forward-looking indicators of economic activity continue to be consistent with strong rates of growth, with a principal constraint appearing to be supply bottlenecks and shortages of key components and labour.

However, in recent weeks, Treasury yields appear to have been disconnected from this newsflow, with technical factors related to supply and demand appearing to be the dominant influence driving the market.

In many respects, it may appear that, in a world awash with liquidity, there is effectively too much money chasing too few assets. Paraphrasing Milton Friedman, it appears that asset price inflation is being driven by central bank policies.

With the Fed continuing to buy USD120 billion of securities per month, it seems odd for the US central bank to register its surprise at the level of yields, when it is the Fed’s own actions that are arguably distorting the market.

Taper timing?

As we look ahead, we remain confident that the Federal Open Market Committee (FOMC) will announce a taper to purchases in the next few months. Since the start of 2021, we have looked for this to occur at the September policy meeting.

However, with some lingering uncertainty with respect to the Delta variant, it is possible that this could be deferred by a couple of months – unless jobs data is strong enough for the FOMC to acknowledge that substantial progress has been made in normalising the labour market.

Notwithstanding the taper timing, we remain confident that the Fed will begin hiking interest rates before the end of 2022, with the economy continuing to close the output gap in the months ahead. Inflation is set to remain materially above the Fed’s 2% target over the coming 12–18 months.

Yield talk

Meanwhile, there may be signs that the recent rally in yields is starting to run out of steam and does not have far left to run, unless growth surprises meaningfully to the downside. From this point of view, we would continue to observe a forward-looking probability distribution very much skewed towards higher yields.

Retaining a short duration stance has been testing patience over the summer thus far. As we look to the ‘back to school’ trade in a few weeks from now, we continue to believe that higher rates offer a compelling opportunity to generate returns via positioning on the short side of this move.

Elsewhere, markets have been relatively quiet. The valuation of real yields has been attracting some attention with rates at record lows, notwithstanding an improving growth backdrop. Arguably, this again may be explained by insufficient supply to meet demand.

However, this seems a strange phenomenon when one considers elevated deficits and government debt levels. To put this in context, a 30-year bond with a real yield of -2% is guaranteed to deliver a return of half its value in real terms at its maturity.

From this point of view, smart governments may actually realise that they can pass on the costs of the pandemic to investors in the bond market – rather than taxpayers, who have a vote – if they seek to do so.

It would seem that this temptation to issue more long-dated debt with negative real yields should therefore be compelling. In our opinion, once the distortionary effect of central bank purchases starts to abate, then a correction could be well overdue.

Around the world

European economic data has also been largely constructive over the past week. It would appear that the Delta wave may be in the process of peaking in a number of countries. In the UK, signs that hospitalisation rates have started to ease have been greeted with some optimism.

From a behavioural point of view, it seems that everyday life is still very far from pre-pandemic norms, notwithstanding the removal of nearly all restrictions on activity. Robust earnings have continued to support risk assets.

In China, lingering concerns have seen yields trend lower in anticipation of further policy easing to come.

Meanwhile, in foreign exchange, the US dollar has been relatively rangebound versus most currencies in the past week. In emerging markets, price action remains mixed, although we would highlight relative strength in the Hungarian forint in the wake of firm data and a more hawkish stance from the country’s central bank.

Employment matters

Looking ahead, we believe US labour market data is key, inasmuch as Jay Powell has made any policy moves contingent on evidence of substantial progress in returning towards the levels of full employment seen prior to the onset of Covid.

We believe payrolls data, due later today and again next month, will thus be significant in shaping Fed expectations for September.

Broadly speaking, we feel the outlook is in pretty good shape. Job openings remain elevated and there is growing evidence of employers struggling to fill empty roles. We see an increasing risk that this will start to move wage data in the months ahead.

In this context, it may not be appropriate to expect the unemployment rate to return to its pre-pandemic low, with the Phillips curve relationship between the unemployment rate and inflation undergoing something of a shift over the past 18 months, as participation rates fall and expectations adjust.

Looking ahead

At times, Fed policymakers may observe a rally in yields, and may fret at what the bond market may know and what they themselves cannot see. From this point of view, sometimes it seems that the job of central bankers is to follow what the market dictates. However, when a market is distorted through the central bank’s own policies, this could be a dangerous path to tread.

Ultra-low real yields and solid equity markets have pushed financial conditions indices to all-time records in terms of levels of policy accommodation. Policy has been materially more stimulative than was the case 12 months ago, notwithstanding progress with respect to the economy and Covid in the intervening period.

From this standpoint, we feel it would be surprising if the economy were not to remain strong and for inflationary pressures to continue to accumulate. Maybe Messrs Powell, Clarida and Quarles have already concluded that they won’t be in their seats for too much longer, happy for successors to do the hard work once they are gone.

Anyway, it strikes us that we may be in for ‘interesting’ times ahead. Indeed, we wonder whether some bond bulls may eventually be as shocked when they look at their screens as was Norwegian runner Karsten Warholm following his amazing world record at the Olympic games this week.