New housing starts slid 9.5% in April.
George Frey/Getty Images
“If we ended up with a slightly higher interest-rate environment, it would actually be a plus for society’s point of view and the Fed’s point of view,” declared Janet Yellen, who has a bit more than passing familiarity with the subject.
“We’ve been fighting inflation that’s too low and interest rates that are too low now for a decade,” the Treasury secretary and former Federal Reserve chief said in an interview with Bloomberg this past week. Yet despite the sort of monetary and fiscal expansion previously confined to wartime, government policies seem able only to lift inflation.
Consumer inflation now is running at a 5% annual rate, the fastest pace since mid-2008, and hardly too low by anyone’s standards. Fed policy makers dismiss the current increase as “transitory,” a phenomenon that will fade once the effects of measuring from the past year’s pandemic-depressed price levels end and supply bottlenecks clear up. Others view the price trends as less benign. Deutsche Bank warns that “neglecting inflation leaves global economies sitting on a time bomb.”
If alarms are sounding, they should be loudest in the bond market. Yet precisely the opposite is happening. Following the release of the consumer price data Thursday, the benchmark 10-year Treasury note’s yield fell to 1.43%, its lowest level since early March, and down sharply from its recent high of 1.745% late that month. Lower yields translate into higher bond prices, not what might be expected, given the steady climb in inflation and the signs of economic recovery.
Whatever the case, the continued descent in bond yields has had a salutary effect on stocks. The S&P 500 index closed at a record Thursday, bolstered by technology shares with valuations pumped up by lower long-term interest rates. At the same time, the Cboe Volatility Index, aka the VIX, slumped to around 16, a quiescent reading not seen since that long-ago era before Covid-19.
Amid such optimism (or complacency), the question remains: Why would a rational investor buy bonds that yield well under the rate of inflation? Even the 30-year Treasury, which traded at 2.13% late Thursday, drew ample demand at its auction that day, even though that is below the implied inflation rate of 2.35% over the next decade derived from the Treasury inflation-protected securities market.
There also has been huge buying of investment-grade corporate bonds, even though they provide a near-record-slim yield spread over Treasuries. One rather less obvious reason for this is that corporate pension plans have become relatively flush, in part because of the record stock market (which boosts their asset values) and the earlier rise in interest rates (which reduces the net present value of their future liabilities). Private pension plans were 98.8% funded at the end of May, compared with 98.4% in April and a recent low of 82% last July, according to Bank of America.
Corporations can transfer pension assets into an annuity from an insurance company. That effectively rids them of headaches caused by balance-sheet volatility or an earnings drag resulting from pension accounting, according to a report by the bank’s credit strategy team, led by Hans Mikkelsen. This is a major business for insurers, which buy bonds to fund the annuities they write.
Such technical factors aside, the fundamentals of accelerating inflation would seem to supersede all else. That, after all, is the predictable result from the Fed’s balance sheet nearly doubling in size from before the pandemic, to $7.9 trillion, and a budget deficit on track to top last year’s record $3 trillion. And recently, the bond market seemed to be following that script, as the 10-year Treasury’s yield rose from just under 1% at the end of 2020 to nearly 1.75%. But instead of continuing on to 2%, as most forecasters and market participants had expected, the benchmark yield has slipped under 1.50%.
The redoubtable David Rosenberg suggests that all the “bad news” for bonds—huge fiscal and monetary juice, double-digit economic growth, reports of widespread wage increases, plus expectations of more infrastructure spending and further reopening as vaccinations spread—is already priced into the market.
“What isn’t in the price is a second-half growth relapse in the economy,” the head of the eponymous Rosenberg Research writes. “Anyone see the 8% slide in auto sales in May?”
Similarly, A. Gary Shilling, who also heads an advisory firm bearing his name, writes in a client letter that the housing bubble, while nowhere near as inflated as during the aughts, is beginning to deflate. In April, existing home sales fell for the third straight month, while new housing starts slid 9.5%. In addition, building permits have been in a downtrend. (What Rosie and Gary also have in common is having been shown the door by Merrill Lynch decades ago for less-than-bullish, but prescient, forecasts.)
The message of the befuddling recent bond action could be that the inflation now all too apparent was discounted in the sharp rise in yields during the first quarter. Yields’ subsequent decline suggests slower growth ahead in the year’s second half and beyond. That lower yields are a global phenomenon implies that these economic effects extend beyond the U.S.
Or, given Yellen’s professed endorsement of higher inflation and interest rates, it could be another example of a mission only half-accomplished by government.
Write to Randall W. Forsyth at [email protected]
