It is all in marked contrast to last week when anxiety about inflation gripped America’s bond market. The steady fall in bond prices since the start of the year had suddenly quickened to a pace that threatened a destabilizing rout. On February 25th the benchmark ten-year Treasury spiked above 1.6%, still low by historical standards, but a lot higher than it started the day, or indeed the year. That prompted a big one-day fall in the S&P 500 and a bigger fall in the tech-heavy NASDAQ. Almost as suddenly, fears have receded again, but perhaps not for long.
Much of what has happened is to be expected. Bond prices ought to fall as the economy recovers. The ten-year Treasury is the benchmark bond and is thus a barometer of risk appetite in markets and economic confidence more broadly. Bond prices move in the opposite direction to confidence; bond yields go in the same direction as confidence. When the outlook for the economy is bleak, as it was last March, yields fall sharply as investors rush to the safety of bonds. As the outlook brightens, bond prices start to fall and yields start to rise again. Bond prices are thus countercyclical most of the time. This feature makes them very attractive diversifiers for equities, the prices of which are more procyclical, moving up and down in tandem with the economic cycle.
Mild inflation is not to be feared. Indeed it is in part changes in the market’s expectations of inflation that drive bond yields down in recessions and up in recoveries. But hopes for a reflation of the economy can quickly spill over into fear of a sustained rise in inflation. The case for this seems stronger than it has for many years. The American economy is recovering quickly. Fiscal transfers have left householders with lots of extra savings. Lockdowns have given rise to pent-up demand. Already there is plenty of fuel for a spending spree when the economy reopens in earnest. And more is on the way. President Joe Biden’s $1.9trn stimulus package is likely to become law this month. A jump in the annual inflation rate seems assured in the coming months, if only because prices were depressed a year ago. Perhaps, then, the strength of spending, as consumers start to move around more freely, might further push it up.
These latent anxieties form the backdrop to last week’s turmoil. Three factors, in particular, seemed to be at work. First, the market for future short-term rates started to price in interest-rate increases by the Federal Reserve by early 2023, sooner than the Fed had indicated thus far. You can call this the inflation-fear element: if the economy seemingly has this much momentum behind it, can the Fed hold off from raising rates for very long? And if the Fed tightens sooner, might the peak in interest rates be higher? That would be a big concern for America’s stockmarkets, where high prices relative to future earnings are largely justified by the expectation that interest rates will remain very low for a long time.
Second, just as the market was having a rethink about Fed policy, the Treasury held auctions for two-year, five-year, and seven-year bond issues. These are maturities that are sensitive to shifts in expectations about Fed policy in 2023-24. Indeed the rise in the five-year bond yield was notable (see chart). The auctions went poorly. The seven-year bond had the lowest bid-to-cover ratio (a gauge of excess demand) for an issue of its kind for more than a decade. This further spooked the market about the underlying demand for bonds. Third, the volatility in the bond market seems to have caused liquidity to dry up. So for a given volume of selling, prices fell further than they otherwise might have. Each factor reinforced the other, perhaps explaining the turmoil.
Given the anxieties about inflation, you may wonder why the bond market recovered its poise. There are limits to how far an inflation scare can run this early in the economic recovery. The message from Fed governors has generally been that they are not even thinking about raising rates or cutting back on bond purchases. The intervention by the Reserve Bank of Australia is a reminder that central banks have the firepower to cap bond yields if they are determined to do so. And some private-sector investors will see value in Treasuries at these yields. Foreign buyers from Japan and Europe, for instance, where yields are lower, may find them attractive.
Calm has been restored. The bond market has settled down. The equity market is back to doing what it does best: breezily going up. You might then put the events of last week down to “technical issues”, the catch-all explanation for many a financial-market scare. But that would be a little too sanguine. These sorts of scares will recur. Inflation is the bogeyman of financial markets. A whole constellation of expensive assets depends on its quiescence. No one can yet be confident that it will stay subdued. Further bouts of bond-market jitters are likely before the year is out.