LONDON: One of the highest U.S. inflation prints in decades has drawn a stifled yawn from bond markets, making it harder to see what – short of a dramatic and unlikely central bank rethink – could budge long-term borrowing rates much further.
Overseas demand for U.S. Treasuries is brimming just as new sales of long-term debt are projected to drop. Such a tightening of supply is counter-intuitive given current eye-popping government spending and may help explain what looks like some screwy market maths.
Unadjusted for inflation, the U.S. economy grew more than 10 per cent on an annualised basis in the first quarter. This week’s numbers showed inflation topping 4 per cent for the first time in over a decade, with a “core” rate excluding food and energy prices at an annual 3 per cent for the first time since the mid-1990s.
But 10-year Treasury borrowing rates are just 1.7 per cent – where they were before the COVID-19 shock last year, and down even from April despite the inflation surprise and a $41 billion auction on Wednesday.
Of course, the Fed and the White House quickly hosed down any speculation about higher interest rates by restating their view that the inflation pop was “transitory” and mostly down to pandemic-related bottlenecks and base effects that will fade as lockdowns end and activity normalises.
Many investors agree.
Bond fund manager Andrew Mulliner at Janus Henderson reckons inflation pricing in bond markets – where five- and 10-year inflation expectations are around 2.7 per cent and 2.5 per cent – is “increasingly excessive”.
“For now we see higher bond yields as an opportunity to add exposure to our funds and ultimately we expect inflation expectations to fall from their current lofty levels,” he said.
But there are other dynamics beyond the inflation view.
Stephen Jen and Joana Friere at hedge fund Eurizon SLJ say quantitative easing bond purchases by central banks around the world will keep U.S. bond maths “distorted” relative to growth and inflation.
In a recent note, they said the traditional correlation between nominal U.S. growth and Treasury yields had been deliberately dismantled by QE over the past 12 years, describing the policy as a “positive supply shock” for bonds, equities and economic output.
“U.S. bond yields, like those in much of the rest of the world, no longer contain useful and reliable information on the economic outlook,” Jen and Friere wrote, adding investors over-interpreted bond market moves despite this ongoing “repression”.
SHRINKING ‘FREE FLOAT’
Their key point is that the scale of bond-buying by the European Central Bank, Bank of Japan and Bank of England relative to underlying fiscal deficits – 161 per cent, 110 per cent and 129 per cent respectively – means all three effectively hoover out of the market more bonds than their governments are selling.
That shrinks the amount available for private investors needing safe assets in the main global reserve currencies.
As the equivalent buying ratio for the Fed is much lower – now just 37 per cent of U.S. deficits – the impact over 10 years has been to almost double the share of Treasuries in global “free float” bond indices of the four top reserve currencies, to 60 per cent.
This, along with the rise of index-tracking funds and retirement demographics, means private-sector demand for U.S. Treasuries from home and abroad has more than offset a stalling of central bank demand from China and others over the decade.
Overseas central banks have increased their Treasuries holdings by $500 billion since 2011 – while domestic and foreign private investors upped theirs by some $10.5 trillion.
“Demand for U.S. Treasuries from global savers will remain very strong because of a shortage of safe-haven sovereign bonds due to the massive QE operations,” Jen and Friere wrote, making it more likely that yields will remain inappropriately low relative to growth and inflation.
And that’s just the demand side of the equation.
HSBC’s U.S. rates strategist Lawrence Dyer sees the 10-year Treasury yield at just 1.0 per cent at year-end – a forecast he says is based on supply dynamics and a predicted drop in the U.S. fiscal deficit to 5 per cent by financial year 2023 from a whopping 15 per cent now.
Dyer reckons past front-loading of longer-term debt sales will reverse as funding needs subside. He expects a 25 per cent drop in auction volumes of seven- to 30-year bonds, which have doubled since the pandemic shock, with reduced long-term issuance then spread evenly between bills and notes of five years and less.
“This year could mark a peak in bond supply, with the deficit projected to shrink significantly,” Dyer said.
All this pushes back against fears that post-pandemic inflation scares could trigger a bond rout that in turn seeds crashes in all interest-rate sensitive or long-duration assets, from tech stocks to credit and emerging markets.
The Fed could, of course, still change the game by signalling an early taper. But with no such move seen imminent, the bond market could hang around these levels for a lot longer.