Consumer prices paid by city dwellers in the United States rose more than 7% last month and more than 9% in April on an annualized basis. If this holds for the rest of the year, it will be the highest rate of inflation America has seen since the 1980s. But fear not, some investors and the US Federal Reserve say the market bond is not worried. Yields have fallen over the previous week and remain low from historic levels even after rising following Jay Powell’s speech on Wednesday. And if the markets aren’t worried, maybe we shouldn’t be either.
However, there are reasons to be concerned about rising prices, and the bond market should offer no comfort.
In theory, bonds are a barometer of future inflation. If inflation is high for the next 10 years, that would reduce the yield on a 10-year note. So investors want to be compensated for what they think is inflation, or for the risk involved when the outlook is uncertain. If inflation expectations or risk rise, bond yields should rise, but the opposite has happened in America in recent weeks. This means one of two things: inflation will moderate, or bond prices do not accurately reflect inflation risks.
Historically, bond yields have not been very good at predicting inflation.
Over the past 70 years, bond yields rarely rose before inflation, only rising after inflation took hold. One study found that past inflation trends were a better predictor of bond rates than what future inflation turned out to be.
Does this mean bond traders are wrong? Not necessarily. It may just reflect the fact that inflation is unpredictable and bond traders don’t know more about the future than the rest of us. All they have is past data and current prices to make their predictions as well. So when inflation suddenly rises, as in the past, bond traders are just as surprised as everyone else.
Bond markets, however, are even less predictive now. Even though bond traders had a magical ability to predict the future, they do not fully determine bond prices. In the first quarter of 2021, the expanding balance sheet of the US Federal Reserve accounted for over 70% of the growth in outstanding public debt. Many financial institutions also buy a lot of bonds; Deposit-taking institutions and insurance companies accounted for around 8% of new treasury bonds purchased last year, in part because government bonds are considered low-risk assets and therefore should be held for regulatory reasons.
In 2020, the Fed, government, banks and insurance companies accounted for over 64% of new public debt. Pension funds also buy bonds, regardless of their inflation outlook, to cover their liabilities. Not only that, fewer bonds were issued in the first quarter of 2021 compared to the last quarter of 2020. In short, US Treasuries have a large captive market due to government policy and then the supply was scaled down. That alone could lower bond yields and overwhelm the inflationary fears of bond speculators.
Meanwhile, declining yields should be a cause for concern. The current upturn in inflation may indeed be temporary, linked to the inevitable setbacks linked to the return of a dormant economy that has misaligned supply and demand. But it is possible that the effects are long-lasting and that inflation may return after almost 40 years of decline. Even temporary inflation can become permanent if it changes long-term expectations. Or maybe the world is entering an era of less trade, which will result in more expensive goods.
And the fact that the government is such a big buyer of bonds is a source of risk. The policy could change. The Fed could decide to curb inflation if it takes hold. And if so, he will stop buying bonds and start selling them instead. This not only risks cutting an economic recovery short, but also causing huge upheaval in the bond market when it loses a massive buyer of debt.
The US government has historically relied on selling the global asset without risk, meaning that whatever it does (even monetize debt), yields plummeted as foreign buyers continued to buy bonds. American. In recent years, their appetites have waned, although they also remain a source of vulnerability. Even though they are buying fewer bonds now, foreign buyers still hold about 25% of the outstanding debt. If they get nervous, they could also sell and add even more trouble to the bond market.
No one can predict the future, even bond buyers. All we have is data on past and current market prices to make sense of things. These two elements suggest that interest rates and yields will remain low. But there are significant sources of risk ahead and reasons to believe this time could be different. Current data should not convince investors to lower their guard.
Allison Schrager is a Bloomberg Opinion columnist and author of An Economist Walks In A Brothel: And Other Unexpected Places To Understand Risk.
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