Fixed Income Commentary – October 2021

“The Chain”

Fleetwood Mac


Key Takeaways

September saw yields move higher, out of the range they held for most of the third quarter, as Fed Chair Powell announced a tapering plan will come to fruition, likely after its November meeting. Supply chain disruptions and labor shortages are still headlines impacting the global economy, but Fed Chair Powell views these as transitory issues.

September in Review

  • The 10- year Treasury yield finished the month with a yield of 1.49%, up 18 bps month over month.
  • The move higher in rates had most fixed income sectors red on the month, with Treasuries leading the move lower, down 1.08%.
  • September’s “dot plot” showed some movement among the Committee members toward rate hikes in 2022 and a more rapid pace of hikes in 2023.

 


Commentary

“Supply chains” may not have been top of mind for most of our readers in the past, but the recent bottlenecks across many industries now makes it a key area of focus. Going in to the third quarter, many were predicting a booming economy due to the lifting of COVID-related restrictions and the robust savings of the U.S. consumer thanks to government largesse. What happened instead was the Delta variant, signs of growth peaking, rampant supply chain disruptions, and China’s actions to combat inequality. For the month, the Bloomberg U.S. Intermediate Aggregate Bond Index returned -0.51%.

September proved pivotal for bond yields as the all-important 10-year Treasury yield broke out of the range it had held for most of the third quarter. Fed Chair Powell’s comments at the September 22 post-FOMC news conference caused bond yields to break higher as it became apparent that the Fed will announce a tapering plan after its November meeting. The “dot plot” showed some movement among the Committee members toward rate hikes in 2022 and a more rapid pace of hikes in 2023. Lastly, the Fed’s official inflation forecast was bumped up a bit. All of these changes, while subtle, indicate a slightly less patient and less tolerant Fed. That was all the market needed to send yields higher.

 

 

As for the booming economy, it’s worth recalling that second quarter growth clocked in at 6.7% (annual rate, real GDP) following the 6.4% pace for the first quarter. With the resumption of “normal” economic activity, some were expecting an even higher result for the third quarter. Even though the actual figure won’t be known for another month, much of the real-time data parsed by economists during the third quarter was inconsistent — some reports suggested rapid growth was continuing, while others reflected a clear weakening in the pace of growth.

Much of the disparity in economic data was due to the widespread supply chain disruptions affecting a broad array of industries, both here and abroad. Tales of shortages abound, while pictures of ships idling offshore from congested ports are further evidence that a global pandemic combined with forced shutdowns of entire countries inflicts a plethora of consequences. Once kinks start to develop in supply chains, further complications arise as companies must scramble to obtain replacements or alternatives, but these are not always an option and certainly not without price or quality compromises. Labor shortages are also part of this narrative since they affect the pace of production or service provided. These supply chain problems have in turn led to higher inflation, which is the most acute impact on the bond market (see Exhibit 1 for day rates on shipping containers). The impact on economic growth is also of great importance to the bond market.

 

 

Fortunately, corporate profit margins are healthy so many companies are better-positioned to absorb some of these price increases, but many are choosing to pass them along and test the market’s willingness to pay higher prices. Fed Chair Powell’s view that much of the current inflation uptick will prove transitory is largely due to these pandemic-related issues that lie behind much of the inflation story, and the same holds true for other nations experiencing the same problems.

All of this confusion is a sign of just how immense and complex the U.S. economy is, not to mention the global economy, and the unprecedented nature of a forced shut-down of vast segments of the economy continues to stymie economic forecasts. At the same time, the political shift in the U.S. has given new life to the focus on the environment which is also happening around the world. These “green” efforts are already colliding with other market and natural forces and adding to the inflation angst from supply chain chaos.

Despite the debt paydown and higher savings exhibited by the U.S. consumer over the last year, spending patterns in recent weeks appear to be cautious rather than exuberant. Some of this could be explained by many of the price increases from supply chain problems, but we suspect some could also be a function of aging demographics. Studies have shown that as consumers age, they spend less on goods and more on services. The services sector of the economy remains heavily impacted by labor shortages and returning COVID restrictions that are likely limiting how rapidly the consumer is able to spend. There are only so many dinners a restaurant can serve on any particular night, and even fewer than normal if they are short-staffed or short on veal.

Another aspect of aging is the need for retirement savings, so it should not come as a huge shock to see many choosing to save any “found money” they might have received during the pandemic. Early retirements do seem to have picked up since the pandemic as some may have done some soul-searching and decided to leave jobs deemed too risky or too taxing on their well-being. Given the average level of retirement savings, however, it would seem likely these actions are being taken by the more affluent rather than lower-wage earners, so many questions remain regarding the labor shortage.

Why the big focus on these issues in a fixed income commentary? All of these actions by consumers ultimately affect the pace of economic growth. If GDP growth falls back to levels seen in the last decade, then prospects for numerous Fed rate hikes should diminish. As well, our macro growth outlook informs our views on corporate earnings and other factors affecting credit ratings.

We hope these comments prove helpful for you in understanding recent fixed income market developments and we welcome any questions should you wish to discuss or learn more.