Expect the unexpected in the bond market

J.P. Szafranski, BridgeTower Media Newswires

Expect the unexpected. 2020 certainly reminded us of this maxim. The economic shock dealt from COVID was rapid and severe. The United States Federal Reserve reacted swiftly in pursuit of its dual mandate of stable prices and full employment. Its Federal Open Market Committee (FOMC) accelerated the easing cycle that previously began in the second half of 2019 in response to the trade war’s impact on economic activity. Before March was over, the FOMC’s target rate for overnight bank lending fell all the way back to zero.

Current consensus among investors and policymakers alike is for low rates as far as the eye can see. Market-based metrics like Fed Fund and Overnight Indexed Swap futures price in 0% Fed Funds for at least three years. Of the 16 members of the FOMC, only one sees a lift off of zero by 2022, and just four see it happening by sometime in 2023.

These expectations are reasonable. But that doesn’t mean bond investors are certain to be stuck without yield forever. The FOMC only directly controls the shortest-term (overnight) rate in the market. While it can influence longer-term yields through bond-buying programs, there are other factors at play.

Inflation expectations is one such factor. One market-based indicator comes from U.S. Treasury Inflation-Protected Securities (TIPS). The TIPS-implied inflation expectation fell drastically to 0.76% in March but is now higher than it was at the beginning of the year at 1.82%.

While there is still a lot of lost ground to make up, the economic recovery from COVID has been surprisingly rapid. With vaccines nearing approval and further fiscal stimulus of some sort likely coming, longer-term bond yields have already started rising. The benchmark 10-Year Treasury Note is over 0.90% versus 0.50% earlier in the year.

There is plenty more room to run for long-term rates, even with the Fed stuck at zero. If unemployment continues its rapid recovery, currently at 6.9% versus 14.7% in April and the Fed’s Capacity Utilization metric tightens further from 72.8% versus about 78% prior to the downturn, we could see much higher interest rates. During the past two cyclical recoveries, long-term rates have traded close to 3% higher than short-term rates (Two Year Treasury notes vs. Ten Year Treasury notes).

Another factor outside the Fed’s control is the globalized capital market. Despite our best efforts to build walls, in many ways, we are more intricately connected than ever with the 7.7 billion other souls traipsing around planet Earth. Much in the same way that someone in China might eat an under-cooked bat and unwittingly unleash a novel virus upon humanity, the economic and monetary circumstances abroad affect interest rates in the United States and vice versa.

Capital is free to flow across oceans and countless borders in pursuit of returns. Europe’s slow economic growth, low inflation and rock bottom interest rates have undoubtedly impacted long-term interest rates in the United States, as international investors rationally try to ditch negative yielding German Bunds for positive-yielding U.S. Treasurys.

Will Europe’s low rates continue forever? Probably not. It’s hard to handicap how Brexit’s implementation might affect things. Longer-term, questions remain about the continued viability of the European Monetary Union. If that began to break apart, who knows what happens to inflation and growth expectations. Will it happen? Who knows. In the meantime, expect the unexpected.

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J.P. Szafranski is CEO of Meliora Capital in Tulsa (www.melcapital.com).