A man wearing a protective face mask walks past 14 Wall Street in New York’s financial district on November 19, 2020.
Shannon Stapleton | Reuters
A volatile environment for government bonds reflects a highly uncertain future for the US economy, pointing to both slower growth and persistent inflation.
After a surge earlier this year that scared the markets, government bond yields fell sharply as investors shifted their focus from concerns about price hikes to the potential that the rapid post-pandemic outbreak could slow.
In the 1970s, the mix of higher prices and lower growth was known as “stagflation,” a pejorative that has received little attention since inflation has remained tame for the past few decades.
However, the word is becoming more common these days as the growth picture becomes cloudy.
“The market deals with the issue of stagflation,” said Aneta Markowska, CFO at Jefferies. “There is an idea that these price hikes will destroy demand, create a policy mistake, and ultimately slow growth.”
For her part, Markowska believes the trade, which plunged 10-year government bond yields from a high of around 1.75% in late March to around 1.18% earlier this week, is a mistake. Yields trade in opposite directions, so a slump there means investors are buying bonds and driving prices up.
She sees a strong consumer and an imminent supply burst that will reverse the current bottleneck that has driven prices to their highest levels since the 2008 financial crisis and create plenty of momentum to sustain growth without creating runaway inflation. Markowska sees the Federal Reserve on the sidelines until at least 2023, despite recent market prices, that the central bank will begin raising rates in late 2022.
“The consensus predicts growth of 3%. I think we could grow by 4 to 5% next year, ”said Markowska. “Not only is the consumer still very healthy, but at some point you will have massive restocking. Even if demand falls, supply has so much to catch up with. You will see the mother of all restocking.” Cycles.”
The bond market, which, unlike the go-go stock market, is generally considered to be the more sober component of the financial markets, does not seem to be as convinced.
Low growth world is coming back
The 10-year treasury is considered a guideline for fixed-income securities and generally a barometer for the development of the economy and interest rates. Even with yields rallying on Wednesday, a 1.29% government bond isn’t expressing much confidence in future growth trajectory.
“Our outlook is moderate growth and inflation,” said Michael Collins, senior portfolio manager at PGIM Fixed Income. “I don’t care what growth and inflation looks like this year, what matters to our 10-year Treasury forecast is what it will look like over 10 years. And I think it will go down again. This is the world we live in. “
The note refers to a sub-trend growth environment with interest rates well below standard.
As the economy outgrew the government-mandated pandemic shutdown, GDP was well above the trend of around 2% since the end of the Great Recession in 2009. The Covid recession has been the shortest on record since mid-2020, the economy has been a rocket.
However, Collins expects the world to return with modest growth and that investors will keep returns within that subdued range.
“The US will continue to lead in terms of global growth and economic dynamism,” he said. “But 1.5% to 2% is our speed limit for growth unless we have a productivity miracle.”
Measure the effects of inflation
So the question that emerges is inflation.
Consumer prices rose a remarkable 5.4% in June, while producer prices rose 7.3%. Both numbers suggest continued price pressures, which even Fed chairman Jerome Powell admitted was more aggressive and persistent than he and his central bank colleagues expected.
While the decline in yields suggests that at least some of the worries are off the market, any other signs that inflation will last longer than policymakers expect could quickly change investor minds.
This is due to the swirling dynamism that threatens to stir up this stagflation specter. The biggest growth concern right now is centered around the threat from Covid-19 and its Delta variant. Slowing growth and rising inflation could be fatal to the current investment landscape.
“If the virus spreads quickly again, it would slow economic growth and prolong the inflationary supply chain disruptions that afflict so many industries as semiconductors and housing,” said Nancy Davis, founder of Quadratic Capital Management and portfolio manager at Quadratic Interest Rate Volatility and Inflation Hedge Exchange Traded Fund.
“Stagflation is an even greater risk for investors than inflation,” added Davis.
However, Collins said that he views the current 10-year return as fair value given the circumstances.
The treasury market is often far more conscious than its stock-centric counterpart, which can fluctuate wildly on both good and bad headlines. At its current level, the bond market is cautiously looking to the future.
As the equity market has been very sensitive to developments in bonds recently, this could mean a certain volatility on the equity side.
“Given what has happened in the past 18 months and the problems much of the world will face over the next 2-3 years, a 10-year increase of 1.2% is understandable,” wrote Nick Colas , Co-founder of DataTrek Research. “It doesn’t mean stocks will have a tough remainder of 2021 or that a crash is imminent. It means Treasuries have a healthy respect for history, especially the below-average US inflation of the past decade. “
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