The 10-year Treasury note is around 1.5%, which is significantly lower than the highs reached in March. Bond yields tend to rise when investors expect higher growth or inflation and nudge central banks to raise rates. This raises the question: Why are bond yields falling as US inflation is spiking?
Two main sets of forces are influencing the path of inflation. On the one hand, structural forces –including debt levels, globalization, and technology adoption – have acted to hold down inflation. On the other hand, cyclical momentum is stimulating inflation, as supply struggles to keep up with stronger-than-expected demand.
In recent weeks, my colleague, Senior Economist Simona Mocuta, has focused on the risk that the current rise in inflation may be stickier than the market expects. While this risk is certainly plausible and may very well be realized, the picture is clouded by many factors, both structural and cyclical. This leaves us less confident in making a directional call on interest rates based on the outlook for inflation alone.
We see five key elements that are holding interest rates and yields down, despite obvious near-term inflationary pressure:
1. Interest rates currently reflect long-term trends in underlying economic activity. You may think that’s crazy with inflation in May coming in at 5% while interest rates are only at 1.5%, but remember that at this time last year there was no inflation at all and many were worried about outright deflation and negative oil prices. The noise in the data associated with the pandemic and subsequent recovery should be viewed as just that – noise. Longer-term trends are much more influential in how we determine the appropriate level for interest rates and, given what we know today, there doesn’t appear to be a significant disconnect (see Figure 1). You could argue that these long-term trends will reverse and start a steady march higher, but we prefer to wait and see.
Figure 1. Forward Interest Rates and Trend Growth/Inflation (%)
Source: Bloomberg, State Street Global Advisors calculations.
2. Following an extensive review of its policy framework, the Federal Reserve adopted an amended “Statement on Longer-Run Goals and Monetary Policy Strategy” in August 2020 that places more emphasis on employment relative to inflation, recognizing that forecasts for inflation have not been constructive and communicating that the zero lower bound poses significant challenges to its ability to react to economic downturns. Our estimates suggest that this new policy framework will result in lower policy rates relative to underlying economic activity. –to the tune of 0.5%. This serves as an additional anchor for interest rates.
3. 1.5% yields are not attractive relative to where they have been in the past, but relative to other choices investors have they don’t look all that bad. Bank deposits offer zero, equity valuations are high, and you have to pay for the privilege of owning many foreign government bonds. You could take more risk and look to high yield or emerging market bonds, but, of course, you would be taking more risk. With a patient Federal Reserve, longer-term bonds in the US actually look quite attractive to many investors.
4. Interest rates peaked in March of 2021 and have trended lower steadily since, despite heightened fears of inflation. By itself, this serves as a signal that the factors above are gaining traction among investors, leading to increased demand for bonds. This will continue until the factors themselves change or investors have fully squared their positions, which takes time.
5. Lastly, it’s quite possible that the change in direction of interest rates presages a forthcoming peak in macroeconomic momentum. Lumber prices have already begun to fall back to earth, fiscal support is likely to wane through the latter half of this year and into next, and investors extrapolating the past 12 months likely now have heightened expectations that are increasingly difficult to fulfill.
Inflation is one input among many when we consider how to position our clients’ portfolios with respect to interest-rate sensitivity. Even as inflation spikes in the near term, there are additional factors that make interest rates attractive at today’s levels. So, although we were underweight duration in portfolios through the beginning of the year, we have been buying duration back over the last several months.
As we continue to monitor the market, we will update our views regularly. If you would like to connect with us to learn more about the topics raised here, please contact your State Street Global Advisors relationship manager.
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