Anyone expecting a return engagement from the bond market vigilantes this year has been disappointed. To find any sightings of them, you’d need to send out an expeditionary force.
Inflation, as measured by the Consumer Price Index (CPI), has been running at 5.4%, or 1.3% above economists'consensus, for several months. Yet the bond market remains unfazed, even though most experts who determine bond prices have been wrong repeatedly in 2021.
“Three inflation prints have been off the charts” and the consensus in the bond market keeps growing more confident they agree with the Fed that inflation will be “transitory,” Erik Weisman, MFS Investments chief economist and portfolio manager, noted. Given the yawning chasm between perceived consensus and reality, one would think markets might reflect a higher degree of uncertainty.
Instead, yields on 10-year Treasury bonds have stood in the 1.3%-1.4% area for most of the last month. Part of this is driven by Fed policy. More observers are questioning why the central bank is applying remedies it used after the housing crisis a decade ago, like buying mortgage-backed securities, when there is a housing boom underway.
Real yields, which are indexed to non-seasonally adjusted CPI, are running at about negative 101 basis points, or 1.01%, and real GDP is expected to rise 7% this year, Weisman continued. Nominal GDP could surge 10%.
Many other economists and market strategists have been surprised by the apparent disconnect between the bond market and economic reality. On a recent Friday morning following a strong employment gain of 850,000 new jobs, JP Morgan Asset Management's chief market strategist David Kelly said the rally in 10-year U.S. Treasury bonds seemed somewhat incongruous. This morning BlackRock CEO Larry Fink told CNBC that inflation is unlikely to be transitory.
The bond market isn't buying into a narrative that many Americans are feeling every day in the supermarket and the gas pumps. “It defies logic,” Weisman says. “It should be in no way obvious that the market is right.”
He and other bond market professionals think it is perfectly plausible that yields on 10-year Treasurys could rise to 2.50% in the next 18 months, as many bond market professionals expect.
After all, at 2.50% those yields would be in the bottom decile of historical payout levels over the last 70 years, Weisman said. Yet were that to happen, those same 10-year government bonds would lose 8% or 9% in value. Accepting the current coupon of 1.33% for the next decade seems like meager compensation for the risk, he added.
But long-dated government bonds have been falling ever since the economy reopened and started displaying robust growth this past spring. Have the bond market vigilantes simply rolled over and waved the white flag?
It would appear that two decades of slow growth and low inflation have left them conditioned to accept that the new normal outlined by Pimco a decade ago will last forever. But Weisman points out the pandemic recession was different from the Great Financial Crisis in almost every way.
The U.S. economy emerged from the 2007-2009 recession with bank and household balance sheets in tatters. Both groups engaged in sustained deleveraging, while the federal government embraced austerity. The upshot was it took years to narrow the output gap, Weisman said.