Treasuries Inflation Gauge Exceeds 2% for First Time Since 2018
Traders see U.S. inflation averaging at least 2% per year over the coming decade, the first time expectations have climbed that high since 2018. Treasuries Inflation Gauge Exceeds 2% for First Time Since 2018
The move came as real yields plumbed record lows.
The 10-year breakeven rate — a measure that draws on pricing for inflation-linked Treasuries — rose as high as 2.017% Monday, a level last seen more than two years ago, data compiled by Bloomberg show.
The gauge has gained momentum as traders prepare for an uptick in the world economy in the wake of a deal on Brexit and the approval of additional virus-relief aid in the U.S. The roll-out of vaccinations against the coronavirus is also fueling the move higher, as is speculation that Tuesday’s U.S. Senate runoff elections in Georgia could give Democrats control of Congress.
“There’s a general expectation that the increase in demand as things return to normal will lead to higher inflation because supply chains are still disrupted,” said Michael Pond, head of inflation-linked market strategy at Barclays Capital. The possibility that Democrats will win Tuesday’s votes creates additional upside potential for breakevens, he said. “If we do have unified government, more can get done and we’ll probably see a bit more fiscal stimulus.”
The Federal Reserve is setting the tone for markets, making a renewed push to revive inflation — which has been too low for years. In August, policy makers announced that they would seek inflation that averages 2% over time by allowing price pressures to overshoot after periods of weakness. Buoying expectations for inflation is key to lifting inflation itself, officials have said.
Aided by a rebound in energy prices, the breakeven rate has widened steadily since November, after Joe Biden won the U.S. presidential election. Biden has nominated former Fed Chair Janet Yellen to head the Treasury, which some investors see signaling the potential for stronger cooperation between the department and the central bank.
The flip side of the climb in inflation expectations is that real yields — which strip out the effects of inflation — have been spiraling lower. Ten-year real rates sank to a record low of about minus 1.124% on Monday.
Treasuries Breaching 1% On Democratic Win May Just Be The Start
U.S. Treasury yields broke above 1% for the first time since the pandemic-driven turmoil in March, and the selloff may only have just begun should the Democrats secure control of the U.S. Senate.
The 10-year yield, a key global benchmark interest rate, at one point surged close to 10 basis points to more than 1.05% as Democratic victories appeared likely in both Senate runoff elections in Georgia, paving the way for more spending to revive the U.S. economy. Long-bond rates, meanwhile, were on track for their biggest one-day jump since March’s pandemic-related turmoil and investors have already started to dust off reflation trades in anticipation of a so-called Blue Sweep.
“The result will certainly be seen as a driver of higher Treasury yields,” said James Athey, a money manager at Aberdeen Standard Investments. “The reflation trade has already been sparked. The question really is how much further the Senate result will push that.”
Should 10-year yields climb higher from 1%, investors said it could spark a domino effect across asset classes if the increase is accompanied by economic recovery and moderate levels of inflation. A gauge of the dollar approached the lowest level since 2018 and most commodity prices rose.
The spread between five- and 30-year bond yields hit its steepest level since November 2016, when Donald Trump’s election sparked trades premised on stronger growth and higher inflation.
The 30-year yield at one point rose close to 13 basis points on the day and even after paring its move slightly remained on course for the biggest single-day advance since March. Back then, the turmoil surrounding the pandemic drove a number of daily moves both ways in excess of 20 basis points, including a 40 basis point shift on March 17.
While the pandemic is still raging with the rollout of vaccines in the early stages, the risk is that further signs of inflationary pressure will start to see bets on Federal Reserve rate hikes materialize.
U.S. 10-year breakevens, a market gauge of inflation expectations over the next decade, topped 2% this week for the first time since 2018, having gained in each of the last three months. At around 2.09%, the measure is within sight of 2018’s high of 2.2078%, and a breach of that level would put it in territory unseen since 2014.
European longer-dated government bonds also fell, with the German 10-year yield rising more than five basis points.
“It’s a clear steepener trade and fixed-income selloff,” said Richard Kelly, head of global strategy at Toronto-Dominion Bank. “The initial reaction here should be ‘fiscal on,’ and that does support higher rates.”
Democrat Raphael Warnock ousted Republican Kelly Loeffler in Georgia, the Associated Press reported, leaving control of the chamber in question until the result of the state’s other runoff election is decided.
Treasury yields gained ahead of the U.S. elections in November, propelled in part by the expectation of more stimulus under a Democratic administration. The breach of 1% completes a journey that began on March 3, when early indications of what the pandemic might mean for the U.S. economy pushed the yield below that level for the first time. Over the following week, it fell to a record low 0.314%.
Higher yields will lead the Federal Reserve to intervene only if the move jeopardizes current easy financial conditions, according to Ed Al-Hussainy, a portfolio strategist at Columbia Threadneedle. He sees potential for the 30-year Treasury yield to climb to 2.25%-2.50%, from the current 1.78%.
“I can see 10-year Treasury yields rising to 1.5% to 2% in short order if more and more uncertainty gets behind us,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd in Singapore.
Fed’s Kaplan Expects Temporary Inflation Spikes During Recovery
Bouts of higher inflation won’t be surprising and while they’ll likely be transitory, it’ll be something to watch closely, said Federal Reserve Bank of Dallas President Robert Kaplan.
“The temporary jump in inflation or rise won’t surprise me — the question for me will be how persistent is it,” Kaplan said Tuesday in an interview on Bloomberg Television with Mike McKee. “For me the jury is out on that right now.”
A recovery from the Covid-19 pandemic this year, bolstered by vaccine distributions and increased economic activity, will drive growth, lower unemployment and probably propel some increase in prices as consumers return to more widespread economic engagement.
“We’re going to make big improvements on unemployment and it wouldn’t be surprising to see the cyclical elements of inflation build,” Kaplan said. “But I don’t think those are going to be persistent, I don’t think those are going to be long term.”
The Fed held interest rates near zero last month to help the country weather the virus, and vowed to keep buying Treasuries and mortgage backed securities at a $120 billion monthly pace until “substantial further progress” had been made on employment and inflation.
Critics say the ultra-easy monetary policy is fanning frothy financial markets and point to extreme volatility in the shares of companies like GameStop Corp.
Kaplan, who is not a voter this year on the rate-setting Federal Open Market Committee, said Fed policy was appropriately aggressive during the pandemic and he did not see evidence of systemic risk. But policy makers should acknowledge that their extraordinary actions are having an impact on asset prices and should be withdrawn once the crisis has passed.
“I’m very concerned and watching excess risk-taking and excess imbalances, particularly in the non-bank financial sector,” Kaplan said. “The issue is, while we’re fighting this pandemic, and until its clear we’re out of the woods, I think we’ve got to be aggressive.”
History Tells Us To Worry About Inflation
Macroeconomics always has its fads: The latest is embracing public debt and not worrying about inflation. But fashions change very quickly.
Just like clothes and food, macroeconomics has its fashions. The latest is for public debt. From the OECD to the International Monetary Fund, global organizations that traditionally supported fiscal restraint have become much more relaxed about sovereign borrowing.
The argument is that debt sustainability is less of a problem if central banks keep interest rates ultra-low. Governments should ditch old fetishes, such as the ratio between debt and gross domestic product, and concentrate on more meaningful measures like interest payments as a percentage of GDP. You can see the appeal. Look at Greece, where a change in borrowing costs and loan maturities has made a huge debt pile seem manageable.
However, this latest macroeconomic fad is based on one crucial assumption: that inflation will stay subdued, letting central bankers continue with low rates and big asset purchases. That’s a pretty big thing to rely on. Any sustained rise in inflation might prompt the U.S. Federal Reserve and its global peers to tighten monetary policy, in order to hit their inflation targets.
Investor attention would then shift back to traditional — much less comforting — measures such as debt-to-GDP ratios, raising the prospect of financial instability.
Economic history is dotted with iron laws that didn’t endure. In the 1960s, governments were convinced of the stable relationship between inflation and unemployment — known as the “Phillips curve.” Politicians assumed they could simply pick a point on this curve depending on whether they preferred to protect jobs or keep prices in check.
One consequence was the so-called “stop and go” policies, whereby governments engaged in a succession of stimulus and austerity as they sought to navigate this trade-off. It took Milton Friedman’s landmark 1967 address at the “American Economic Association” and the stagflation of the 1970s to show things weren’t so simple. Today’s economists treat the Phillips curve with caution.
Another example is the “great moderation” of the 1990s and 2000s, when policy makers in advanced economies believed they’d tamed the business cycle permanently. Some credited the establishment of independent central banks with inflation targets, which in theory anchored price rise expectations and prevented governments from overheating the economy.
It turned out there were other more subtle factors governing rich-world inflation, including globalization, the technology revolution and China’s entry to the World Trade Organization. The 2008 financial crisis and the great recession killed off any claims about an end to “boom and and bust.”
Many economists will, as ever, claim that this time is different. They offer various explanations of why inflation will be permanently low or negative, including: technology’s moderating effect on prices; the deflationary impact of an ageing society; and the role of inequality in constraining overall spending.
Evidence since the 2008 crisis supports those who are unworried by inflation spikes. Central banks have engaged in unprecedented stimulus, which critics feared would trigger hyperinflation. But they’re still struggling to lift inflation toward its typical target of about 2%.
However, one cannot assume that the near future will be like the recent past. The post-pandemic world will offer a first test of whether low inflation is here to stay. As demand surges, supply constraints continue to bite and companies tries to rebuild their profits, we may see a reemergence of price pressures.
There are powerful forces going in the opposite direction, too, such as the large number of people who’ll lose their jobs or suffer wage cuts. But inflation may not be gone forever. In the euro zone, core inflation — excluding volatile items such as food and energy — jumped to 1.4% in January, its highest in more than five years (though this was largely due to temporary factors).
In the U.S., President Joe Biden’s proposed $1.9tn stimulus program has spooked some economists, including former Treasury Secretary Larry Summers and Olivier Blanchard, the IMF’s former chief economist, who are worried about its inflationary consequences.
In theory, inflation need not be a bad thing for public debt. Accelerating prices have helped governments tackle previous debt mountains because they push up tax revenues, while what is owed remains fixed in nominal terms. Nations will also benefit from the favorable debt structures they built during years of disinflation. This includes low rates, longer maturities and a large portion of sovereign debt held by sovereign banks.
And yet, this ignores financial market dynamics. As inflation returns, it’s easy to imagine investors rushing for the exit as they try to avoid bond losses. If debt-to-GDP does become voguish again, things could look ugly. Central banks wouldn’t be able to intervene, in fear of compromising their commitment to inflation targeting.
There are two things for policy makers to consider here. The first is the quality of government spending. Politicians must do all they can to support their economies as the pandemic rages on. Even after they’ve rolled out their vaccination programs, states should keep the help coming, especially for families that have suffered the most.
However, as Italian prime minister-in-waiting Mario Draghi, said last summer, there are “good” and “bad” debts, since some wisely targeted spending programs do much more to lift a country’s long-run growth rate. Countries who’ve used their borrowings unproductively will struggle if instability returns.
The second thing for central banks to think about is their own position. In the U.S. the Fed has made clear that it’s willing to tolerate periods of higher inflation, which could help lessen fears of sudden monetary tightening. The European Central Bank is in the middle of a strategy review, and will need to ask itself this same question.
Just because you promise that you’ll ignore higher inflation doesn’t mean the market will believe you. But the Fed is right to set out what it thinks. Any change in central bank priorities needs to be communicated promptly.
We are indeed living through a revolution in macroeconomics, but facts will change one day. Governments and central banks must prepare.
Long-End Yields Surge In Biggest Treasury Selloff Since January
The selloff in Treasuries sent the yield on the 30-year bond surging on Wednesday, putting the long-end benchmark on track for its biggest one-day advance since early January.
Rates climbed across notes and bonds, with the long-end increasing most and the curve steepening. The 30-year yield jumped by around 11 basis points at one stage, hitting a one-year high of 2.29%, while the 10-year rate rose as much as 9 basis points to 1.43%.
Global bond markets are suffering this year amid the prospects for U.S. stmulus and a surging reflationary narrative, with volatility gauges climbing to multi-month highs. That’s prompted fears over a potential tantrum in havens, such as Treasuries and German bonds. While Federal Reserve Chairman Jerome Powell this week called the recent run-up in bond yields “a statement of confidence” in the economic outlook, the move raises pressure on central banks to keep financing conditions easy.
“The market is nervous about additional stimulus, worried about the risks of higher inflation, and concerned about QE tapering,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities. “The selloff is likely being exacerbated by convexity hedging and positioning stop-outs.”
Soaring Treasury Yields Are Worrying Economists — But What Does This Mean For Bitcoin?
The price of gold has also been stagnating, but this isn’t necessarily bad for “digital gold” Bitcoin.
This week’s correction in the price of Bitcoin (BTC) showed that a market doesn’t go up in a straight line. Meanwhile, another topic has been gaining attention, namely the big rise in the 10-year yields of United States government bonds.
In recent weeks, the 10-year Treasury yield of U.S. government bonds has surged 35% to a new high of 1.44%, the highest point since the cross-asset crash in March 2020.
Treasury Yield Bounces From A 60-Year Low
The 10-year Treasury yield has been accelerating massively in recent weeks, similar to the run-up to the economic downturns in 2000 and 2008. Hence, rising yields are typically considered a signal of weakness for the economy and can have a big impact across many markets.
As the yields increase, governments must pay more for their underlying government bonds. This combined with the current economic conditions of the post-COVID-19 era and record national debt are factors that are unsurprisingly worrying economists.
However, looking at the chart above from a technical perspective, this entire run can still be considered as a simple bearish retest of the previous support level.
Such an example is shown by the previous attempt to test the resistance above. This could be happening here as well, where the rates will then drop back down from the 1.53% level. But it is important to keep an eye on this level because breaking through it can have a major impact on the markets.
The government bond yields also have an impact on mortgage markets. Given that the real estate market is massively overheated at the moment, with people taking on massive debt to purchase homes, an increase in interest rates could pop this entire bubble, similar to what happened in 2008.
However, yields also impact other markets, as gold often reacts to these moves as well. But is this time different? And how will Bitcoin respond to these potential macroeconomic shocks?
A Weakening Dollar Vs. Bitcoin
The U.S. dollar currency index (DXY) index continues to show weakness as yields are rising, which is generally good news for Bitcoin bulls. This suggests that investors are fleeing the dollar toward higher risk, higher reward investments, such as Bitcoin.
However, from a technical perspective, the DXY saw a bearish retest at 91.50 points, followed by more downside for the dollar, as seen in the chart above. Now, a retest of the 90 points level is underway, with the primary question being whether this level will hold as support.
Nevertheless, it’s debatable whether the rise in yields is having any direct effect on the price of Bitcoin, particularly in recent days. Meanwhile, the DXY has often been inversely correlated with the price of Bitcoin, though this has been decreasing in recent months (see below).
After the crash in March 2020, this inverse relationship grew stronger until September 2020, as a weakening dollar was accompanied by a major increase in BTC price.
Of course, assets are only correlated until they aren’t, and many other factors can have a much bigger impact on BTC in the short term — for example, miners or whales selling Bitcoin, government regulations, etc.
Why Is Gold Showing Weakness?
The 3-day chart for gold’s price shows a clear-cut correction since August 2020. More importantly, the increase in yields and the weaker dollar have not impacted the gold market as much as Bitcoin’s market.
Even with the recent surge in yields, people are not buying gold. In fact, an increase in yields has historically not benefitted gold — at least not in the short term — because higher yields would make government bonds more attractive for funds to hold for settlement and as a risk-off asset in their portfolios.
When yields continue rising toward higher levels, however, the uncertainty surrounding the economy also increases, and investors typically begin to shift from the dollar to gold as a safe haven. This was seen in the 1980s when yields ran toward 14% and gold also spiked to new all-time highs.
BTC Has Become Increasingly Important In Macroeconomics
In the current state, however, falling gold prices may simply be an immediate reaction to the increase in yields in general.
However, another possibility is that an increasing number of investors are opting for “digital gold” instead of the precious metal, not only because of the higher upside potential — i.e., risk-reward — but also because these positions can be liquidated much easier.
But another possibility is that an increasing number of investors are preferring “digital gold” to the precious metal — not only because of the higher upside potential but also because these positions can be liquidated much easier on digital trading platforms.
— Willy Woo (@woonomic) February 25, 2021
Today, the market capitalization of Bitcoin is still only 7% to 10% of gold’s, which highlights this massive upside potential.
Therefore, the macro conclusion that can be drawn is that the markets are becoming increasingly uncertain about the economy’s and the dollar’s future, as exemplified by the rising 10-year Treasury yields. However, it’s still too early to write off the recent correction in BTC price to this macroeconomic development, as multiple other variables are at play.
Ultimately, the rising yields and a weakening dollar are exciting developments to keep an eye on moving forward.
With Bitcoin becoming an increasingly important player in the macroeconomic environment, strategists at JPMorgan Chase, for example, believe BTC may continue to eat away at gold’s market share. This will likely result in an even higher valuation for Bitcoin, particularly in the event of another economic crisis at the expense of gold.
In December 2020, JPMorgan Strategists Noted:
“The adoption of bitcoin by institutional investors has only begun, while for gold, its adoption by institutional investors is very advanced. If this medium to longer-term thesis proves right, the price of gold would suffer from a structural headwind over the coming years.”
Markets are signaling that inflation is coming and investors are getting ready. Treasury yields are rising and stock-market investors are starting to shift from high-growth tech companies toward companies like airlines that will benefit from an economic rebound.
But one corner of the Treasury market suggests that a coming bump in U.S. inflation will run out of steam swiftly. This has implications for fans of gold or cryptocurrencies who fret about runaway inflation.
Investors’ inflation expectations can be seen in Treasury markets by looking at the difference between the yields on ordinary Treasurys and the yields on inflation protected Treasurys, known as TIPS. This difference is called the break-even rate.
The difference between five-year Treasury and TIPS yields shows break-even inflation expectations have risen to nearly 2.4% in recent days—the highest level since May 2011, implying inflation is set to pick up.
But there is more going on below the surface. Shorter-term break-even rates are higher than longer-term ones, an extremely rare situation—known as an inversion of the break-even curve. This forecasts a spike in inflation that then falls away.
For instance, longer-term inflation expectations are lower: 10-year break-even rates are 2.15% and 30-year rates are 2.1%.
The five-year rate hasn’t been above the 10-year since July 2008, according to FactSet, and the gap between the two has never been as great as it was on Wednesday.
Interpretations for the anomaly vary. One possibility is that the $1.9 trillion coronavirus-relief package Washington will vote on this week will bring only short-term benefits—and only a short-lived bump to inflation. More than three-quarters of the funds likely to be approved will be spent on stimulus checks and other income support, according to Goldman Sachs estimates.
Another view is that the inversion in break-even rates might signal expectations that the Federal Reserve—contrary to promises—will react swiftly to cap inflation and keep it close to its 2% target.
“It may signal that we are getting closer to the first test of the Fed’s commitment to average inflation targeting…and not tightening policy until they see the whites in the eyes of inflation,” said David Riley, chief investment strategist at BlueBay Asset Management.
This idea is supported by the fact that yields on 10-year TIPS—known as “real” yields because they take into account inflation expectations—have risen as 10-year break-even rates have fallen over the past two weeks. That combination, Mr. Riley said, typically signals either a weaker growth outlook, which seems unlikely, or a higher likelihood of rate rises from the Fed.
Another support for this view: Fed-funds futures put an 11% chance on the central bank lifting interest rates by a quarter of a percent in September, up from a zero chance just a month ago.
A third view is that the market is simply getting it wrong and underpricing the effect of government stimulus spending.
That could come in the form of an infrastructure spending package to be agreed upon later this year after the initial coronavirus relief.
Alberto Gallo, head of global credit strategies at Algebris Investments, thinks there could be a longer spell of healthy inflation if investments are made in ways that boost U.S. productivity growth. But to truly work, this would also require higher corporate taxes and better antitrust regulation to improve competition in the U.S., he says.
There is also still a lingering concern about the economic pain that a cycle of rising interest rates would cause in a world saddled with even more debt than households, companies and governments were bearing before Covid-19 struck. Higher rates divert more income into debt repayments, slowing spending on other things and hurting economic activity.
The last time there was a series of rate rises from the Fed it ended with a sharp selloff in stocks and riskier debt at the end of 2018 as investors worried the central bank was going to go too far.
Treasuries’ Worst Quarter Since 2016 Ends With Questions Aplenty
As bond traders wrap up the worst quarter for Treasuries since the aftermath of 2016’s surprise U.S. presidential election result, there’s no shortage of mystery surrounding what comes next.
First and foremost, there’s the likelihood of another massive government-stimulus package — featuring infrastructure spending, this time — that could tally as much as $3 trillion. Traders are just starting to debate whether the tax increases expected to be included would offset the stimulative benefits to the economy, and how that calculation might play out in the world’s biggest bond market.
The debate in Washington over further spending comes as bonds have hit a lull, rebounding modestly this week after a punishing stretch that drove yields to pre-pandemic heights. In options, the cost of hedging against higher yields has eased, although the tilt remains bearish.
One force in the days ahead may play into that shift and help cap yields for now: quarter-end rebalancing that spurs buying by pension funds. But all eyes will be on the economic proposal that President Joe Biden says he’ll unveil next week.
“The reason the market hasn’t wrapped its head around this second plan yet is because of the tax component,” said Michael Franzese, managing partner at MCAP LLC. “The bottom line, for me as a market maker and position taker, is that I don’t see the necessity of having to do anything. Tax hikes are more detrimental than the positives that we might gain from infrastructure expense.”
For now, Franzese says he’s relying on monthly and weekly employment data to determine how quickly the current $1.9 trillion round of stimulus is working and to see if he should resume selling Treasuries maturing in seven years and out.
The government will release March payrolls figures on the April 2 Good Friday holiday, when U.S. stocks are closed and the bond market is open for a half day. Economists project that job gains likely surged this month.
Also next week, quarter-end rebalancing may drive investors into fixed income and out of equities, given the rally in stocks and the bond selloff. Bank of America Corp. strategists, for example, estimate that $41 billion of U.S. private pension funds will flow into Treasuries over the quarter, with the bulk of that still to come before the end of March.
The 10-year note, a benchmark for global borrowing, yields 1.68%, down from the more than one-year high of 1.75% touched in mid-March. The reflation trade fueled by previous rounds of stimulus and ultra-loose Federal Reserve policy has Treasuries down 3.79% this year through March 25. It would be the biggest quarterly loss since Donald Trump’s 2016 election victory.
Still at issue in the market’s calculus behind the next round of stimulus is the amount of tax hikes in the plan.
For Chevy Chase Trust’s Craig Pernick, the stimulative potential of the spending figures being discussed in Washington may overshadow concern about the headwinds from tax hikes.
“The market has always anticipated there was going to be some infrastructure package, but not yet fully understood what that would look like,” said Pernick, the firm’s head of fixed income. “Depending on how it’s paid for, it could go either way. I would be more concerned that it pushes rates moderately higher, throwing more fuel on the fire of economic growth.”