Fixed Income Commentary – June 2021

“Slow & Steady”

Of Monsters & Men


Key Takeaways

Like last month, bond yields were relatively unchanged even as the economy continues to heat up, equity markets continue to rally, and inflation measures creep higher. Investors are left to debate whether the most recent signs of inflation will persist or are just transitory due to the pandemic’s impact on certain segments of the supply chain. For now, the Fed has embraced a new paradigm of allowing above-target inflation.

May in Review

  • The 10- year Treasury yield finished the month with a yield of 1.59%, down 4bps month over month.
  • MBS struggled on the month, down 0.18%.
  • Munis continued their run, up 0.30%.

 


Commentary

When crossing through a covered bridge, slow and steady is the way to go.  Bond yields proved slow and steady by hardly changing in May even as the economy continued to ramp up, inflation measures creeped higher, and equity markets rallied.  With minimal price action occurring, the total return for the month was driven by income: the Bloomberg Barclays Intermediate Aggregate Index returned 0.22% for the month of May.

We probably listen to the financial news more than most of our readers and it is certainly interesting to hear how frequently the topic of inflation is raised by commentators.  Even though Fed Chair Powell and nearly all other Fed Governors have opined that inflation is expected to rise, but mostly for transitory reasons, one or two months of higher inflation seems too much for the commentators to bear.  If they were the Fed Chair, we would likely have a 5% fed funds rate by now and equity markets would likely be in correction mode.

This barrage of criticism about higher inflation brings to mind a conversation with a friend a number of years back when the Fed was steadily raising rates due to the expectation that inflation would rise if the economy were left unchecked, or in other words, the standard or old way of doing things.  This friend was of the view that inflation was not going to be a problem and the Fed was being overly concerned.  Damned if you do, damned if you don’t.

Now that the Fed is embracing a new paradigm of allowing above-target inflation to occur in order to offset the years of below-target inflation — all with the goal of achieving the target on average — there is controversy about the merits of the idea.  Will the Fed allow inflation to suddenly surge ahead for a sustained period of time and lose its ability to contain it?  That is the fear being expressed by some commentators, who gleefully report that inflation expectations are climbing.  Could it be that their own repeated discussions about inflation are causing the rise in inflation expectations?  The point here is that Fed officials have had inflation targets in place for years and have failed to meet them, so they are trying to learn from the past by changing their focus to outcome-based policies.  In theory, this means when the Fed ultimately does raise short term interest rates, the public will understand why they are taking action and will support it, which in turn should temper any rise in inflation expectations.

Many components of higher inflation in the latest reports appear to be from pandemic-related issues which suggests they will be transitory rather than persistent.  For example, airfares plunged last year and are now heading back toward prior levels (which is one of the “base effects” we alluded to last month), while used vehicle prices have moved higher due to chip shortages that have impacted new vehicle production.  What seems to be lost on the commentators who are trying to scare the public about higher inflation is the simple fact that consumers and businesses can, and likely will, begin to change buying habits if price increases prove too onerous.  For many products and services, price increases may prove difficult to stick, and also difficult to repeat.  This likelihood is just one factor behind our view that higher inflation will not become a persistent problem.  The best cure for high prices is high prices.  In other words, supply will eventually increase or substitution will ensue, and price stabilization or reductions will then typically result.

 

Some Fed officials have acknowledged the likelihood that discussions will begin soon on changing the pace of asset purchases, or perhaps the mix (currently $120B Treasuries and MBS each month).  We would welcome a smaller pace of purchases and a shift to all Treasuries: the mortgage market is functioning well and does not need any assistance from the Fed, in our opinion.  One of the key challenges in this gradual process centers on the communication strategy.  Since the Fed has been so adamant about waiting for labor market conditions to improve before tightening policy (phasing out bond purchases, raising rates), it will be quite challenging to communicate any changes to its policies without causing large changes to bond yields, particularly if conditions for one of their goals (employment) do not merit any change while conditions for the other (inflation) do.

We expect the Fed’s annual conclave in August at Jackson Hole will present a good opportunity for a beginning salvo in the delicate communication process that needs to take place around tapering asset purchases.  Fireworks are usually reserved for July, but August may prove just as exciting.