Treasury Yields: Short-Term Jumps and Long-Term Gains

A Global Crash and Bounce

Thanks to the global pandemic and subsequent lockdowns, the world suffered a deflationary shock during the first two quarters of 2020. After the collapse of commodity prices and the fall of equity prices, there was a dollar shortage. By the end of February 2020, the “forced selling” of gold and Treasuries was already well underway. 

Governments from all around the world, including the United States, began a relief effort that poured massive resources into the existing money supply. With huge deficits to cover, governments everywhere created new base money to purchase more government bonds. In the United States alone, the Federal Reserve bought $1 trillion worth of Treasuries in March and April. They have continued to purchase an average of $80 billion in Treasuries per month ever since, thereby pumping massive liquidity into the economy.

Asset Inflation and Commodity Reflation

As one might expect, anything scarce relative to demand has soared in price. This has included items seemingly as disparate as semiconductor chips and ribeye steaks. Gold, silver, copper, and iron ore reached new highs on the commodities market. Food commodities were also impacted as the prices for soybeans, wheat, and beef climbed. To top it off, supply chain issues caused by global lockdowns pushed freight rates through the roof. 

This dynamic played out with asset prices as well. Despite the largest downturn in GDP since the Great Depression, the stock market rose to new highs. There seems to be no limit to what investors will pay for growth and tech stocks, relative to earnings. Time will tell if growth stocks endure a valuation reduction.

The question I keep getting more and more is, where and when will price inflation occur? Early in the pandemic, inflation was most visible in financial assets such as commodities and stocks. But with the coronavirus overstaying its welcome, the continued stimulus has seemingly begun to spill over into consumer prices, which ultimately hurts the purchasing power of individuals.

Ongoing Stimulus Potential

So where do we go from here? Several stimulus packages have already been passed and implemented by the U.S. government. The most recent came with a $1.9 trillion price tag. In addition to the stimulus packages already in play, Congress may consider a student loan forgiveness program that could range from $400 billion to $1.4 trillion and an infrastructure bill that may reach as much as $3 trillion! 

It will be critical to keep an eye on these stimulus packages due to the current macro-heavy environment we are operating in. Future inflation levels can be highly influenced by the amount and timing of any further stimulus programs implemented. Stocks, bonds, commodities and currencies would, in turn, also be highly impacted. It’s important to note that these impacts not only come from the stimulus decisions made by our government, but the stimulus decisions of major economies from around the world.

Theoretically, the US government can end inflation quickly by turning off the spigot and allowing the stimulus packages to wind down. However, that could lead to sudden and widespread insolvency problems, which could fuel more civil unrest. That is untenable to career politicians seeking perpetual reelection. At this point in time, large stimulus programs appear to be the game plan despite any potential risks of higher inflation and the market seems to agree. 

The Steepening Yield Curve

Higher inflation expectations appear to be one of the primary causes of the recently steepening yield curve. Although the difference in rates between the long and short ends of the Treasury curve is widening, it is worth noting that Treasury yields are still below expectations. It’s possible the Federal Reserve will be forced into making monetary decisions sometime in 2021 to control the yield curve. 

It is unclear at this point what those decisions would look like. Typically, the Fed expands the monetary base and cuts interest rates in response to low inflation and high unemployment numbers. On the other hand, a tightened monetary policy and higher interest rates usually accompanies low unemployment and high inflation.  However, high unemployment and high inflation is a horse of a different color and demands extremely careful maneuvering.

In 2020, the Fed announced a policy of "average inflation targeting." Under this policy, they have stated they can support high unemployment with a looser monetary policy and allow inflation to rise, if necessary. This means if stimulus money causes higher inflation in 2021, the Feds may not raise rates to slow it down.  

Two Types of Yield Curve Control

The Federal Reserve has two options they can implement to control the yield curve. The first is a full spectrum control that attempts to “lock” the yield curve wherever they deem appropriate. To accomplish this, they would purchase as many bonds as necessary with newly created base money to manipulate the curve to their target.

The second option would be to focus on the short end of the yield curve by holding short-term interest rates near zero while letting longer-duration Treasury yields continue higher. This would likely have a positive financial impact on banks, but would likely increase most borrowing costs for businesses and individuals. 

As the markets continue to move through 2021, it will be important to watch for additional stimulus packages both in the United States and abroad, as well as the potential for inflation. Regardless of what happens, now is an excellent time to be sure that you fully understand what financial assets you own and why you own them.

If you have any thoughts, or would like to discuss this further, I’d love to hear from you. Call or text me at 772-349-2202, email me at [email protected], or just shoot me a message through LinkedIn.  Thanks for reading!