To be fair, the bond market has priced in at least some of this higher inflation with the yield gap between 10-year nominal Treasuries and 10-year TIPs ending last week at 2.32%. Still, the evidence would seem to support further upside risks to inflation. More significantly, the real 10-year TIP yield remains at an astonishingly low -0.85%. To be clear, this means that an investor buying a 10-year TIP today and holding it to maturity is locking in a guarantee of losing 8.2% of their purchasing power over the next 10-years for the privilege of being allowed to lend money to Uncle Sam.
Technical Forces Suppressing inflation
This reality suggests that something else, other than expectations about the economy or inflation, is suppressing yields in a big way.
One part of the story continues to be low foreign yields. A more sluggish recovery from Covid, relatively low inflation and very easy ECB policies are maintaining 10-year German government bond yields at roughly -0.25% while the Japanese Central Bank is holding 10-year JGB yields at close to 0%. To the extent that global investors see these bonds as substitutes for U.S. Treasuries, their consistently low yields are likely acting as an anchor on U.S. yields.
A second issue is portfolio rebalancing. Since the start of the year, the S&P500 has generated a sparkling return of 13.6%. This has prompted many institutional and individual investors to rebalance, buying bonds and selling stocks. As one measure of this, according to the Investment Company Institute, more than $350 billion has flowed into long-term bond funds and ETFs so far this year compared to just $152 billion on the equity side.
However, the biggest factor may be a temporary lull in the supply of Treasuries. This is not for a lack of stimulative fiscal policy. In fact, in just over four months, between February 3 and June 9, federal outlays exceeded federal revenues by a whopping $1.327 trillion.
Over that same period, the Federal Reserve added $328 billion in Treasuries to its balance sheet as part of its bond-buying program, funding some of this deficit spending.
However, the actions of the Treasury Department have been even more significant and they trace back to events of a year ago.
In the second quarter of 2020, as the economy collapsed into the pandemic recession, the Treasury Department issued almost $3 trillion in additional debt. This was, in fact, well above their cash needs and so they parked the surplus in their general account at the Federal Reserve, which swelled to a peak of almost $1.8 trillion by the end of July 2020. This gigantic stash of cash stayed in this account, more-or-less untouched into early 2021 when the Treasury Department announced that they would be drawing it down to roughly $500 billion by the end of June.
They have stayed on this schedule with the account shrinking from $1.630 trillion on February 3 of this year to $674 billion by June 9. The net impact of this is that, despite very significant fiscal stimulus over this period, total Federal government debt in the hands of the public, excluding the Federal Reserve, rose by just $13 billion over the same period.
It would seem that these factors are more than enough to explain the lack of bounce in Treasury yields in recent months. However, they will likely not last forever. Both Europe and Japan should continue to make progress against the pandemic in the months ahead, potentially putting some upward pressure on their yields. At some stage, equity markets could see a significant correction, requiring investors to rebalance towards stocks rather than bonds. The Treasury drawdown of its account at the Fed is nearing its end and we expect that this week’s Fed communications will hint at a tapering of Fed bond purchases by the end of this year or early next year.
If this transpires, then long-term interest rates will likely resume their ascent, and this should benefit fixed-income investors who are short duration and equity investors who are tilted towards value over growth.
David Kelly is chief global strategist at JPMorgan Funds.