US inflation is high but low-yielding Treasurys are selling like hotcakes.
by Jurrien Timmer, Director or Global Macro, Fidelity Investments
Key takeaways
- With the year-over-year inflation rate rising to 5% in May, it may seem counterintuitive that bond yields have been falling recently. But it makes more sense than it might seem.
- Markets are always looking ahead and are also driven by technical supply and demand factors. Currently, demand for bonds from the Fed remains high, while the supply of new debt has been flat as the Treasury runs down its cash balance at the Fed.
- Despite the high CPI numbers, expectations for future inflation have come down, especially now that the Fed is eyeing an exit from its zero rate policy.
The big market event in early June was the huge Consumer Price Index (CPI) report, which was met by a sharp drop in nominal yields. As of May, the CPI is up 5.0% from a year ago and the 10-year Treasury is yielding a measly 1.48% as of June 22 (down from its recent high of 1.75%). On the surface it doesn't make much sense.
At 1.48% the 10-year is trading well below where it "should" be (2.3% based on my models). The simple notion that quantitative easing (QE) reduces yields goes a long way toward explaining the disconnect. Bond yields move in the opposite direction of price—with the Fed loading up on bonds, demand increases along with the price.
Another reason for the drop in yields despite a spike in inflation could be the lack of debt issuance, as the Treasury continues to draw down its cash balance at the Fed. The Treasury is spending down the Treasury General Account, or TGA, as the debt ceiling looms. The borrowing limit was suspended in 2019 for 2 years and is coming back at the end of July. The cash balance in the TGA needs to be reduced to the previous level from 2019 when the debt ceiling was suspended, per Congressional rules and precedent.
Over the past year, the Treasury has issued $1 trillion less debt than it otherwise would have because of this drawdown. In my view, reduced supply amid ongoing Fed demand, on top of recently shifting expectations for when the Fed's demand will be pared back, are a big part of the current bond dynamic.
The chart below details the recent changes in supply and demand for Treasurys. The market always looks ahead, and with the topic of tapering pushed back to the Jackson Hole conference in August, we may now be seeing something of a reverse taper tantrum in the bond market.
Note that while the net supply has been relatively flat since March, the Fed has added close to $300 billion in bonds.
Another reason for the drop in yields could be that we may have now reached peak inflation after having already reached peak reopening. The 5-year Treasury Inflation-Protected Securities (TIPS) breakeven is down 21 basis points (bps) from the recent high, and the chart below shows that the Fed's Weekly Economic Index peaked a few weeks ago, in lockstep with yields.
Finally, perhaps another reason behind the bid for bonds is that on a currency-hedged basis US yields are very juicy these days for European and Japanese investors. The chart below shows that on a hedged basis the US 10-year yield is 1.37% for Japanese investors and 1.85% for European investors.
In conclusion
So as you can see there are many dynamics playing out in the bond market right now. At the center, demand for Treasury securities remains high—particularly from the Fed—but supply is down. All things beginning equal, that puts upward pressure on prices and downward pressure on yields.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
