Inflation, The 10 Year US Treasury And Factor Markets

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If inflation is such a worry to the chattering class, then why haven't bond yields reacted? The 10 year US Treasury is still stuck around 1.5%. Wither the bond vigilantes? A few insightful answers come from fixed income mega manager Brandywine Global.

While there is much to be gained from reading their most recent perspective, what stands out to me is a view you don't hear all that often: "... in the world of supply shortages, factor markets are the new (bond) vigilantes. Instead of rising bond yields, commodity prices, energy, and wages are rising to bring demand into alignment with supply. Higher prices and slower real income/earnings growth put the brakes on real spending growth. The bond market does not need to act." In other words, the bond vigilantes can chill. The factor markets are doing much of the heavy lifting.

Go wide, go deep.

 

Low Bond Yields: Repressed or Something More Fundamental?

Treasury bonds do not get much respect these days. Institutional fund manager bond weightings are at their lowest levels ever in the 20-year history of Bank of America’s monthly fund manager survey. High profile investors treat them like the plague.

The revulsion in sentiment is easy to understand. Who wants to own a negative real yielding asset? Based on the personal consumption expenditures price index, also known as the PCE deflator, real bond yields have been lower only once in the last 60 years while inflation is already at its highest level in 30 years—the real culprit. Many investors see inflation as the number one tail risk in the economic outlook. The fear is that inflation proves hotter, higher, and longer lasting than Federal Reserve (Fed) officials think, a consequence of the staggering fiscal and monetary stimulus brought to bear on the economy over the last 18 months. In the wake of all that stimulus sit trillions of dollars in liquid bank accounts, theoretically a powder keg of inflationary firepower if households and businesses decide to spend the money.

So why is the 10-year nominal Treasury yield stuck near 1.5%? Yields are even below May 2021 levels despite an 11% growth rate in nominal gross domestic product (GDP) in the last two quarters. Is a bloodbath for the bond market lurking around the corner?

 

Financial Repression?

The usual answer for low yields is financial repression. Fed purchases of government debt artificially support bond prices and suppress yields, not to mention distort other asset prices and sustain zombie corporations.

Intuitively appealing, flow data supports the idea to some extent. Fed purchases have absorbed a whopping $4.4 trillion of Treasury and agency bond supply since the last week of February through late October. Accordingly, last week’s announcement by the Fed of a $15 billion monthly tapering of purchases might be a game changer. It means an eventual reduction of $1.4 trillion in bond buying a year, which should imply higher yields based on this thinking. However, the government will be tapering its issuance of bonds by even more.

None of this allows for the flows generated from buying and selling of the existing stock of government debt. Presumably, the bearish argument for bonds should discourage holders of the outstanding stock of debt, implying far more potential supply pressure than represented by new Treasury issuance alone. That has not been the case. Instead, it has been the opposite.

Continue reading at Brandywine Global.