The Great Shutdown
COVID-19: The return of the state
The response to the pandemic has seen governments intervene in economies, financial markets and everyday life with unprecedented speed and reach. I...
Apr 20, 2021
Philip Saunders – Co-Head of Multi-Asset Growth
Following the Covid related plunge, bond yields had been remarkably quiescent throughout the balance of 2020. Late last year, this was cited by many as non-confirmation of the recovery. Yet even before the vaccine announcements in November, there were signs of a powerful rebound in industrial production, led by China. Pan forwards to the current quarter and US 10-year Treasury bond yields have experienced their most dramatic rise in 50 years, effectively unwinding all of the decline in yields after Wuhan was locked down. If you had had the misfortune to own a 20+ year US Treasury bond ETF you would have suffered a loss of c. 13.6% over the first quarter. Other bond markets have fared somewhat better but have also been impacted by the gravitational pull of a sharply steeper US yield curve.
This move has triggered — and has been reinforced by — a shift in narrative. Concerns about economic relapses, which had dominated market narratives, have been replaced by concerns about inflation from rapidly recovering economies in the short term and an upward shift in fiscal spending over the longer term. In reality, much of the coverage has conflated the near-term and medium-term issues. In the near term, sharply rising headline inflation numbers in the United States and elsewhere are actually largely the mechanistic result of low base effects of extremely weak inflation a year or so ago.
There is a medium-term question of whether the rise in long-term rates reflects growing evidence that, led by the Biden administration, we are entering a new policy regime which would give pride of place to sustained deficit spending to boost median incomes. This would be occurring in a context where the world was adjusting to arguably less free trade, certainly more regulation, and monetary policy that has been ‘unorthodox’ for over a decade. Yet as we know from our thematic work on inflation, a durable spell of inflation takes years to form—the inflationary decade of the 1970s had its root in the monetary policy mistakes that began in the early 1960s. Therefore, it is not yet necessary to make a call on whether the inflation has reached a ‘regime change’ moment. After all, to be too early is the same as being wrong.
In any case, worrying about inflation feels very retro, and it is, especially when the term ‘bond vigilantes’ starts being revived. Yet it is clear these worries have driven an adjustment in inflation expectations, which has in turn spurred a powerful rotation in equity markets and strong performances by commodities. In our view, there is every chance of a respite from the seemingly relentless recent rise in long-term interest rates, because from May the base effects that have been making the momentum of change seem so uncomfortable, should fall away and headline inflation rates should moderate as a result.
The base effects behind the recent spike in inflation should reverse from May
Source: Ninety One, Bloomberg as of 31 March 2021
Such a respite, should it occur, would have important implications for performance across asset classes and geographies over the next two quarters. Bonds could rally or at least consolidate, a weaker dollar could take the pressure off emerging markets and some of the rotation that has occurred within equity markets could unwind. Nevertheless, we expect growth to be powerful and globally synchronised over the next 18 months and this pause not to be permanent. The interest rate cycle has by no means run its course.
The key thing to watch is the path of real rates in the years ahead. For now, it is hard not to remain broadly sanguine on risk assets given the quiescent level of real rates. Real five-year rates five years from now are currently 0.11%, well below the circa 2% peak seen after the GFC, let alone in the 1990s. Most of the adjustment in bond yields has been driven by a shift in inflation expectations. Provided real rates remain anchored, risk assets should continue to do well. These fundamental dynamics and anchors should always interest us more than market narratives, which as we saw last year can be quite flawed and a perennial source of misdirection.
A decline in the inflation rate may drag back yields from their recent highs
Source: Ninety One, Bloomberg as of 31 March 2021
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