Are Yields Getting Ahead of Inflation Expectations?
Given the events of last Wednesday, we hope 2021 didn’t just tell 2020, “hold my beer”, but in the Treasury market good times are certainly being priced in. Long-end Treasury yields have risen every day in this young year, until yesterday. Driving that increase is the expectation that the Heroes Act will contribute to growth and inflation and the expectation that a Stimulus 3.0 will be coming from the unified Democratic Congress and Biden Administration, and that will stoke even more growth and inflation. Are those views likely? We discuss that more below.
It’s no secret that intermediate to longer-end Treasury yields have been rising since August but the moves have accelerated in 2021. While Treasury prices managed a small gain yesterday, a closely watched segment of the yield curve pushed above 100 basis points on Monday for the first time since 2017. The spread between the rate on the two- and 10-year notes has risen every single day this year until yesterday as investors bet that additional U.S. fiscal stimulus will lead to more bond issuance and higher yields on longer-maturity Treasuries. In addition, there is speculation the Fed will begin tapering its bond purchases sooner than some think even though several Fed speakers this week have pushed back on that notion and suggested the tapering discussion probably won’t happen until later this year, assuming the economy continues to improve. That being said, all those factors are fueling the yield curve steepening.
One more factor contributing to the steepening has been increases in the TIPS Breakeven Inflation Rates that have risen above 2% and are higher now than pre-pandemic levels. We discuss this in more detail in the next section where we look at the latest inflation numbers. Suffice it to say here, we think the market’s inflation expectations may be getting a little ahead of themselves and that some consolidation of the recent steepening, in both nominal yields and breakeven rates, is likely.
December CPI Not Signaling a Material Lift in Inflation
The December Consumer Price Index came in mostly as expected with the core rate indicating inflation remains docile. The overall monthly increase was 0.4% matching expectations and up from 0.2% in November. Gas prices increased 8.4% accounting for 60% of the monthly price gains. The core rate (ex-food and energy) rose 0.1% also matching the pre-release forecast but down from 0.2% the prior month. The year-over-year rate for the overall was 1.4% slightly higher than the 1.3% expectation and up a two-tenths from the November level. The core YoY rate was 1.6%, matching the November rate and the pre-release expectation. Nominal Treasury yields and TIPS Breakeven Rates have been rising lately as they price in expectations of increasing inflation on the back of fiscal stimulus, and spreading vaccinations. The question is do those rate increases justify the inflation fears?
There is an expectation that with fiscal stimulus and vaccinations making their way through the population pent-up consumer demand, especially in the services sector, will be felt. That could lead to increases in service prices to meet this pent-up demand. Also, goods demand could outstrip virus-damaged supply chains. These, however, will be temporary price moves that spike then fall back as pent-up demand gets satisfied and supply chains get repaired and inventories replenished. A more durable inflation will have to come from the consumer feeling flush with cash that will drive prices permanently higher. Will that be the case? The unemployment rate has been 6.7% for two straight months, more than 3% above the pre-pandemic low of 3.5%. And recall then the economy couldn’t get a durable increase in inflation and certainly didn’t approach the Fed’s 2% target. So, until that labor market slack is worked off, which could take years, we don’t see much risk that we are in store for a durable and material increase in inflation.
Agency Indications — FNMA / FHLMC Callable Rates
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