The sell-off in US Treasuries of late has been driven primarily by expectations that Biden’s USD1.9tn stimulus package will stoke higher levels of inflation and put the US economy on a strong growth path. This has been encouraged by a Federal Reserve that appears to be patting itself on the back for a ‘job well done’ when the risks are still pointed to the downside.
At first look the Biden package looks to be the required tonic with a massive stimulus for the ailing economy, however, further investigation adds to the uncertainty. 40% of the package ($750bln) is for mass inoculations, to fund states and local governments, not a boost to GDP although it should reduce additional job losses. About $1trn is for direct income subsidies to households in the form of rebate cheques, child tax credits and higher unemployment benefits. This is not the same as a tax cut which impacts the economy directly, in fact the economic multiplier of such funding is way below that of tax cuts as spending is usually about half and savings picks up. As an example between March and May 2020 almost USD3tn was passed as stimulus, US personal disposable income shot up by USD2.4tn in that period, but savings jumped USD5tn as consumers saved not only the subsidies but any other income they received.
So, the bulk of the package is open to interpretation as to the economic impact and we feel it is premature to assume continued strong economic activity or a push to higher levels of inflation.
As to inflation, the Fed has said it will run hot for a while. Hard to see in today’s economy when below targeted inflation has been prevalent for the last several years. There are expectations for a boost to inflation which we feel is transitional at best and rebasing in the year over year annualising based on last year’s extreme weakness will show a pickup, but this is a shorter-term statistic.
A recent example of GDP and inflation was Trump's tax cuts in 2017, which amounted to $1.5trln in very direct and permanent economic stimulus aimed at consumer spending and corporate investment. The result was very little impact on GDP or inflation as consumer savings rates jumped but there was a lift in corporate earnings and stock buybacks.
Broadly, lower income families need subsidies to survive, wealthier families are liable to save a substantial portion.
As to the bond market, the selloff in US Treasury yields has been explosive and reminds us of 2018 on ‘speed’. Then yields at ten years moved up 75bp in nine months, this time we have had 75bp in less than three months which did catch us by surprise. We did expect a difficult period for UST later in the year and so had limited exposure to long dated UST, but any exposure was too much. Also, the speed of the rise in treasury yields impacted credit, particularly longer dated, which saw pricing move down. The move in credit was not really a selloff, more a ‘buyers strike’ as dealers moved bid and offer spreads to discourage selling and avoid buying.
Here we are, yields up to price in the inflation and growth risks following the Biden package. Our view remains that inflation expectations are misplaced and that yields not far from today’s levels offer a buying opportunity.
Investment grade bonds, particularly the undervalued ones held within the portfolio, have plenty of scope to rally further. Investors still need income, increasingly so in a world of ageing populations, and that backdrop is supportive for fixed income assets in general. Previous sell-offs like these have been followed by rapid rallies and it would not be a surprise if we see this again in the coming months.
Enjoy your day.