Equity markets had a mixed but muted week. Interestingly, interest rates declined even in the face of rising inflation data. The Consumer Price Index (CPI) increased at its fastest annual rate since 2008 and core CPI, excluding food & energy, increased at its fastest annual rate since 1992. The strength in prices is driven by COVID-pandemic recoveries, which should normalize, but will interest rates continue to shake off the data?
On Thursday, we received the latest inflation data by way of the Consumer Price Index (CPI), which represents a basket that includes food, energy, groceries, housing costs, and sales across a spectrum of goods. CPI rose 5% in May from a year earlier, which is its fastest pace in nearly 13 years, as inflation pressures continued to build in the U.S. economy. The Federal Reserve’s preferred inflation gauge is the Core Personal Consumption Expenditures (PCE) index. We are still a couple of weeks from the release of May data, but April saw core PCE rise 3.1% year-over-year – easily above the Fed’s 2% target and its fastest pace since the 1990s.
Yet, the 10-year US Treasury yield – an interest rate benchmark – seems to have stalled out at 1.74% on March 31st and fallen to 1.47% as of Friday’s close.
Why would interest rates recede while inflation is surging, and annual economic growth is projected at its highest level in nearly 40 years?
The bond market is clearly weighing in on the debate of whether recent inflation data is transitory or not. And the vote is for transitory/temporary increases to inflation while the economy reopens. The market has shrugged off wide swings in economic data, a spike in inflation figures, and some uncertainty about the direction of fiscal and monetary policies.
On the last point, the Fed has been steadfast regarding not raising the federal funds rate until 2023, but not as resolute about continuing quantitative easing (QE) at the current level of $120 billion of bond purchases each month ($80 billion of US Treasury bonds and $40 billion of mortgage-backed securities). As covered last week, the Fed has been clear that it is putting its employment mandate ahead of its inflation mandate, which gives them cover to keep interest rates at zero. However, it would not be shocking to see the Fed begin to scale back on its bond purchases this year, which would be the first step toward normalizing policy.
The Fed will likely begin to taper bond purchases with a reduction of $10 billion per month in Treasury purchases and $5 billion per month in purchases of mortgage-backed securities. At that pace, it would take about eight months for asset purchases to completely end, although they may opt for a tiered approach. Logically, they may try to time the end of quantitative easing with the end of 2023; then the Fed can consider raising short-term interest rates if the economic outlook warrants it.
Naturally, we need to dig back into the QE tapering playbook for market reactions. The previous comparable time period was the post-financial crisis time from 2010 to 2016. The Fed deployed three rounds of quantitative easing and one period of actual tapering. Each time, yields rose during the QE time period and fell when QE ended, or tapering began – a true “buy the rumor and sell the news” situation. Consequently, investors should be prepared for bond yields to rise in the lead-up to a change in Fed policy, then fall afterwards. That conclusion would lead us to believe that A) the recent stall and decline in interest rates may be a head fake and an unsustainable situation or B) the market expects a near term announcement of tapering.
Interest rates do not operate in a vacuum with inflation expectations and Federal Reserve monetary policy. There is also market supply and demand. To that end, there is outsized international demand for US Treasuries due to the coronavirus pandemic still hampering the global economy. Demand for bonds keeps interest rates lower, but it’s difficult to gauge the contribution effect of quantitative easing and excess international demand.
In my estimation, the current low bond yields are inconsistent with a strengthening economy, the supply of Treasuries to be absorbed by the market, and the risk that inflation consistently runs above 2% for the mid-term. Inflation expectations suggest that the market is currently pricing in a rate of approximately 2.5% over the next 5-10 years. That leaves real yields— current US Treasury yields adjusted for inflation expectations—in negative territory.
In our fixed income model, to compensate for low yields, we believe that investors can take on additional credit risk in a strong economic recovery. And to cushion against the downside risk of rising interest rates, we proactively keep our duration much lower than the overall bond market. Managing duration is especially important now with interest rate spreads at historic lows. Bond managers with flexible investment policies can adjust duration to cushion against falling prices as interest rates rise.
Have a great Sunday!
Timothy W. Ellis, Jr., CPA/PFS, CFP®
Senior Investment Strategist, Wealth Strategist