Long-term interest rates have risen sharply in 2021 so far, with the yield on the 10-year Treasury bond climbing from 0.93% on January 4 to 1.34% by last Friday. This move is a logical reaction to better news on the pandemic, encouraging data on how the economy has weathered an early-winter surge in Covid cases, and rising prospects for significant fiscal stimulus. However, given this positive news flow, the bond market may have under-reacted so far, suggesting that investors need to be positioned for further increases in rates as economic springtime turns to summer.
Data on the pandemic continue to be encouraging. As of February 21, a seven-day moving average of confirmed cases was 66,000, down 74% from its peak in early January, while the number of on-going hospitalizations, at 58,000, had fallen 56% from its peak. Most importantly, fatalities, while still averaging a terrible 1,900 per day over the past week, are down 43% from their mid-January peak.
Despite weather disruptions, the vaccine rollout is continuing with 75 million doses distributed and 63 million administered as of February 21. Last week both Pfizer and Moderna confirmed their plans to supply the U.S. government with 220 million doses of their double-dose vaccines by March 31, 400 million doses by May 31 and 600 million doses by July 31. Even ignoring the likely imminent approval of additional vaccines and allowing for lags in distribution and administration, the data continue to suggest that every American adult who wants the vaccine will be able to get a shot before the end of July. This, combined with those who have acquired some natural immunity through infection, should allow the pandemic to recede over the summer and fade as a factor restraining the economy.
Meanwhile, readings on U.S. economic activity continue to exceed expectations. Last Wednesday’s January retail sales report showed a blockbuster 5.3% increase from December. Part of this gain likely reflected pandemic distortions to holiday seasonal patterns and part likely was due to families receiving the $600 stimulus checks from the December pandemic relief package. It is also undoubtedly the case that consumer spending on services saw less momentum than spending on goods. However, with all of this said, it now looks likely that real consumer spending for January, which will be released this Friday, will show a roughly 2% month-to-month gain. This, in turn, puts real consumer spending for the quarter on track for a gain of between 2% and 3% annualized.
Housing activity was also very strong in January with single-family building permits hitting their highest level in almost 15 years. Data due out this week should also show some continued strength in capital goods shipments. In total, it now appears that real GDP growth could be between 2% and 3% annualized in the first quarter, getting the year off to a better-than-expected start even before receiving the booster shots of a receding pandemic and surging fiscal stimulus.
Numbers on inflation are also likely to warm up. Oil prices have risen sharply in recent months with the price of a barrel of West Texas Intermediate Crude oil climbing from a base of just over $40 last summer and fall to nearly $60 today. Much of this price increase should be sustained as the global economy accelerates in 2021. While inflation, as measured by the personal consumption deflator, should register a relatively tame 1.4% year-over-year gain in January, and could drift slight lower in February, very easy comparisons from March on should push the year-over-year numbers above 2%. Moreover, as the pandemic recedes over the summer, higher demand could boost prices for a very wide swath of services, maintaining inflation at or above the Fed’s long-run 2% target.
And then there is the issue of stimulus. This week, the House of Representatives looks set to pass a version of President Biden’s “Rescue Plan.” On Saturday, the Congressional Budget Office produced an estimate of the budget effects of the House bill. Remarkably, of the $1.9 trillion in the bill, more than $1.2 trillion is expected to be spent in the current fiscal year which ends in seven months, with a further $430 billion to be spent next fiscal year. This bill includes $1,400 rebate checks, enhanced unemployment benefits, cash for ailing businesses and a very wide range of spending on battling the pandemic and helping out cash-strapped state and local governments.
It still looks likely that, with some minor trimming, something close to this bill will pass the Senate in the next few weeks on a strict party-line vote and that the President will sign it into law in mid-March. If this occurs, it should provide a very strong boost to an already fast-recovering economy over the summer and fall.
It should be noted that, at their December meeting, members of the Fed’s Federal Open Market Committee forecast that, as of the fourth quarter of this year, year-over-year real GDP growth would be 4.2%, the unemployment rate would be 5.0% and inflation, as measured by the personal consumption deflator, would be 1.8%. A faster-than-expected retreat of the pandemic, combined with very strong fiscal stimulus, should mean stronger real growth, lower unemployment and higher inflation than the Fed projects.
While the Fed has made it clear that this would not trigger an increase in the federal funds rate, it would likely raise the chances of a tapering of government bond purchases early in 2022. This combined with a synchronous surge in global economic activity, should cause long-term interest rate to rise further.
And finally, investors should recognize just how low long-term interest rates remain. In the 50 years before the Great Financial Crisis, the average ex-post real yield on a 10-year Treasury bond, using core CPI as a deflator, was 2.71% and it only turned negative 6% of the time. In February, we estimate core CPI inflation could slip to 1.3% year-over-year, matching current 10-year Treasury yields. However, in the year ahead, core CPI inflation should be well above 2% putting some upward pressure on yields. More importantly, as the U.S. and global economy surge on the back of fiscal stimulus, real yields should turn positive again.
For investors, this underscores the difficulty in achieving a positive return on high-quality fixed income and the need to find other sources of both income and return in the year ahead.
David Kelly is chief global strategist at JPMorgan Funds.