Risk assets rose in February even after suffering a late-month setback caused by rising longer-term bond yields on growing market concern that fast-pace economic recovery could prime higher inflation. A battle is developing between the bond market’s view that policy growth stimulus could prove excessive driving inflation up earlier and higher than central banks are expecting. Central banks remain adamant that stimulus measures remain appropriate given uncertainty about economic conditions as the world transitions from pandemic containment to Covid-19 becoming endemic. Central banks foresee a slow return of inflation and are prepared to stare down bond market vigilantes with their different inflation view.
The battle between the bond market and the central banks could increase volatility in risk asset prices in the near term. Occasional spikes in bond yields will go together with lower risk asset prices. However, economic growth and growth in corporate earnings are quickening and provide cause to buy dips in the prices of risk assets. The roll out of vaccines means the world can live closer to normally with Covid-19 and with less risk of periodic shutdowns. At the same time, households are primed to spend more drawing on higher savings during the pandemic plus continuing stimulus from government spending and monetary accommodation.
Returning to February, major share markets rose strongly through much of the month before surrendering some gains in the final week. In February gains ranged from 1.0% for Australia’s ASX200 to 4.7% for Japan’s Nikkei. The US S&P 500 rose by 2.6%. Fast rising bond yields in the final week of the month cut back the size of February share market gains.
Credit markets also showed a small gain in February tempered by the rise in government bond yields towards month end. The rise in government bond yields affected longer-dated maturities with shorter-dated bond yields anchored by the RBA’s 0.10% cash rate and three-year bond yield 0.10% cap. The anchoring of shorter-term interest rates out to three-years limits the risk of pressure on banks to lift interest rates on fixed rate home loans. The lift in longer-term bond yields has not changed our earlier assessment that the Australian housing market is improving and allowing the number of housing borrowers on suspended repayments to fall more rapidly than expected.
Turning to government bond markets, the sell-off in longer-term bonds in the last week of February was the sharpest since 1994. Over the month the US 10-year bond yield rose by 33 basis points (bps) to 1.40% while the 30-year treasury yield rose by 32bps to 2.15%. The sell-off in Australian longer-term bonds was greater, up 77bps to 1.90% and prompted the RBA to increase its purchases of 3-year bonds to haul the yield down to 0.10% target.
While neither the US Federal Reserve nor the RBA have set explicit targets for longer-term bond yields the late February yield increases challenge both central banks’ forecasts that inflation will not rise unacceptably over the next two or three years. If sustained, the rise in longer-term bond yields also adds to the interest cost of funding government stimulus spending that the Federal Reserve and RBA deem necessary to ensure sustainable economic recovery.
Both the Federal Reserve and the RBA will work to counter the forces lifting longer-term bond yields. They will repeat at every opportunity the credible analysis behind their forecasts of low inflation persisting. They will operate in money markets to hold down the cash rate and in the case of the RBA to anchor the 3-year bond yield at 0.10%. They may also intervene directly and buy longer-dated bonds.
Although the late February bond market sell-off is reminiscent of 1994 it is different in that the bond market sell-off then was triggered by interest rate rises by the Federal Reserve to contain growth and inflation. The central banks and the bond market were on the same page. Both saw an inflation threat that needed containing. This time the bond market and central banks are at odds about inflation risk. We see central banks backing their view of persistently low inflation forcefully and at times unpredictably.
While the bond market is likely to become warier of central bank intervention occasionally promoting bond rallies a run of strong economic readings, especially in the second half of 2021 will play to its view that higher inflation is approaching. At some point, central banks will need to turn from opposition to the bond market’s higher inflation view to ratification of it, but that point is some way off.
In the case of the RBA, we do not see it changing its low inflation view this year or through much of next year either. The RBA will continue to weigh the continuing signs of stronger-than-expected economic growth against excess capacity evident in an unemployment rate at 6.4% in January still well-above the 5% rate ahead of the Covid-19 outbreak or the 4.5% or lower rate deemed likely to place consistent upward pressure on wages and inflation. The falling but still high unemployment rate readings and low annual growth in wages (1.4% y-o-y in Q4 2020) support the RBA’s view of no untoward lift in inflation this year or next.
The RBA’s 0.10% cash rate and 0.10% 3-year bond yield cap are in no doubt through 2021 and much of 2022. When the bond market tries to sell-off as it did in late-February it buts heads with anchored short-term yields and an intransigent RBA. In this environment bond yields and risk assets look more volatile although in our view the trend-line is more certainly upwards for risk assets than for government bond yields as economies continue to improve this year.