Investors may seem to ignore inflation, but concerns persist.
The 10-year Treasury yield TMUBMUSD10Y,
was trading at 1.46% on Friday, falling despite Thursday’s report that the pace of inflation skyrocketed for a second consecutive month as the economic reopening of the pandemic.
“Inflation is significantly higher than the compensation you get for investing in fixed income securities,” said Eddy Vataru, investment director of Osterweis Capital Management’s total return strategy, in an interview. “Part of the value of being invested in bonds is to preserve purchasing power.”
Fixed income investors worry about rising inflation because it erodes the value of their existing bonds. As inflation fears tend to encourage selling, causing yields to rise, investors are now wondering if the latest signs of inflation are transient or lingering as the economy rebounds.
“I would say there’s a significant part of that that’s lingering,” Vataru said, “but you won’t know for months.”
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Falling 10-year yields doesn’t necessarily mean market participants agree with the Fed that inflation is transient, according to Vataru, whose fixed-income career includes past jobs in hedge fund firm Citadel and asset management giant BlackRock.
Vataru said short positioning in the Treasury market may be part of the reason for lower yields after Thursday’s Consumer Price Index report showed the cost of living rose again in May. , pushing the rate of inflation to a 13-year high of 5%.
Investors in short positions are betting that the prices of Treasuries will fall, pushing up yields, according to Vataru. Bond prices and yields move in opposite directions. If rates don’t rise fast enough or far enough, these investors can get nervous about losses and forfeit their bets. Short sellers become buyers when they hedge their positions.
“A lot of the purchases you’ve seen over the past week are probably short blankets,” Vataru said. “That’s part of the reason why when you have a move like this you don’t quite have the reaction you think otherwise,” he said of the drop in yield on Thursday. in 10 years.
See: The 10-year Treasury yield slips to a new 3-month low as the pace of inflation returns to 2008 levels
Still, yields would be higher if there was more consensus that inflation is a persistent problem, according to Vataru. He said he was particularly worried about signs of wage inflation, as it can be sticky, and believes inflation will be in the range of 3% to 5% “the way we are monitoring in this regard. moment”.
But Ellen Gaske, chief economist for the G-10 economies at PGIM Fixed Income’s Global Macroeconomics Research Group, said the 10-year Treasury yield is up from last year and now matches investor expectations that inflation is transitory.
“We’ve seen reflation trade before,” she said. “We have already seen 10-year yields rebound from 50 basis points last summer to where they are today.”
Gaske explained that the rates “were quickly reflecting” expectations that “we would come out of this crisis.” She now thinks that by the end of this year, the Fed may start cutting back on asset purchases, which, along with low interest rates, is part of its dovish stance.
Earlier this year, Gaske “pushed ahead” of her expectations of a Fed rate hike until the second half of 2023. Previously, she predicted that the Fed would raise its benchmark rate in 2024, with the adjustment of its forecasts made in the first quarter, because the economic dynamic appeared strong with the deployment of vaccinations against COVID-19.
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Gaske expects the spikes in inflation to be likely short-lived, in part because prices are measured against the low levels seen last year, and supply chain bottlenecks that appeared in the rebound in demand will be resolved. But she said accelerating rent-linked inflation caught her attention in the latest CPI reading, adding that this was an area she would be watching closely for potentially higher costs persist.
“I think the Fed itself is sort of in a mess,” Vataru said, as any further characterization by the central bank of inflation as persistent would likely lead to higher rates which would dampen the recovery.
“They almost have to say it’s transient to continue like this,” he said.
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Meanwhile, the Fed’s massive quantitative easing program, or QE, is helping “stoke the fire” despite the absence of structural problems indicating the United States is in recession for years to come, according to Vataru. The United States does not face the same “great debacle” in the throes of the 2008 financial crisis, he said, but monetary and fiscal stimulus continues with stocks near record levels and vaccine deployments resulting in fewer COVID cases at home and abroad.
“It’s a dangerous potion to have a policy that in my mind is really inflationary and then dismiss any inflation that goes through the system as transient,” Vataru said.