In the US, reflation on the back of fiscal stimulus and the exit from lockdowns should lead to modestly higher inflation expectations and nominal bond yields. A renewed ‘taper tantrum’ looks unlikely as excess capacity and high unemployment rates will prevent inflation from reaching a level that would prompt the US Federal Reserve to signal a change in monetary policy. Corporate credit spreads are tight, but a robust US economic recovery this year should permit positive returns from carry.
The fortunes of financial markets continue to be driven by COVID-19 infection rates, virus mutations, vaccine development and rollouts, lockdowns, and the fiscal and monetary policy responses.
The near-term hurdles should eventually be overcome, however, and we believe the arrival of the eagerly awaited post-pandemic world has only been temporarily delayed. Another reason for optimism is further fiscal stimulus in the US. The Federal Reserve is leading central banks in accommodating fiscal stimulus by buying enough government bonds to keep real yields from rising. These factors should enable an accelerated recovery in US economic growth in the second half of the year.
The COVID-19 vaccines are game-changers as long as they can be distributed quickly enough and prove to be robust against emerging strains of the coronavirus. Global deployment of vaccines would mean most public health restrictions could be removed, possibly in the second quarter of 2021, lifting the aggregate supply side of the economy.
Monetary policy, however, has largely exhausted its options for providing stimulus. At this point, its role is to accommodate fiscal stimulus by purchasing the amount of Treasury issuance required to prevent real yields rising. Only fiscal policy can now provide a significant impulse to growth. In this context, the Democrats’ sweep of the White House and Congress sets the scene for a highly expansionary fiscal stance that should support aggregate demand.
The budget resolution approved recently authorises a USD 1.9 trillion coronavirus relief bill. This substantial fiscal package could be passed quickly and without much change if the Biden administration chooses to proceed by the reconciliation process. A bipartisan bill, which would require at least 10 Republican Senators supporting it, would likely be much smaller, but still significant in historical terms.
We expect unprecedented coordination between fiscal and monetary policy, i.e. the administration and the Fed. This means monetary policy will only be tightened once the economy is at full employment. Given the Fed’s Flexible Average Inflation Targeting (FAIT) framework, a tapering of asset purchases and eventual interest rate increases should be some way off – but not as far off as would have been the case without the Georgia Senate seat wins. If it is to be credible, an AIT framework should keep real yields low and push breakeven inflation (BEI) wider (see Exhibit 1).
While we expect much higher Treasury bond issuance, the impact of this additional supply on real yields should be limited. The Fed will buy a large proportion of the net supply. We believe that the Fed would react to an increase in real yields that threatened the recovery and/or equity markets. Instead of worrying about supply, we think the bigger concern for duration positions is that the Fed may taper its asset purchases earlier if the economy returns to full employment faster. We see a modest further bear steepening of the real yield curve as warranted as investors reassess the fiscal and growth outlook.
At the same time, the combination of fewer supply constraints, the injection of fiscal stimulus, the boost to confidence from vaccines and a supportive monetary policy ought to be highly supportive of risk assets and commodity markets. The impact on inflation will likely be modest in the near term, but the prospect of the economy returning to full employment at a fast clip ought to generate price pressures in due course, especially if the Fed delays any monetary tightening until actual evidence of higher inflation emerges.
The Fed’s commitment to its Flexible Average Inflation Targeting framework, however, is not assured, and policymakers will need to build their inflation-boosting credentials. The Fed chose to adopt the weakest form of AIT, and has not followed up with a more forceful policy stance, so we are left to conclude that the consequences of the framework change will only be observable when the economy does return to full employment and inflation pressures emerge.
Given the Fed’s history of under-delivery, some investors can be expected to be reluctant to buy BEIs simply because of a change to the policy framework. This can provide an opportunity if it becomes clear that the Fed is serious about tolerating inflation overshoots, or if it becomes clear that the output gap will close more quickly than anticipated.
While a significant output gap is now putting downward pressure on underlying inflation, the prospect of a rapid reopening of the economy in the context of a highly expansionary fiscal and monetary policy mix means that we are now more constructive on the near and medium-term prospects for underlying inflation in the US.
Longer term, the Biden administration’s focus on reducing inequality is likely to mean legislation that supports unionisation, increased worker benefits, and higher minimum wages. A protectionist stance on China would reverse some of the disinflationary impact of globalisation. A Fed focused on fulfilling its average inflation goal would help.
It is not clear whether these factors will overwhelm the structurally disinflationary forces of technology, but we believe the odds of a pick-up in inflation are higher today than they were before the pandemic.
This is an excerpt from our quarterly outlook for fixed income ‘From Despair to Hope’; click here to access the full version.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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