Why are bond yields rising? Not because of inflation


Bond yields are rising, but not because of inflation, says Joe Lavorgna, chief economist for the Americas at Natixis. On the contrary, he says, the catalyst is the Federal Reserve’s plan to reduce its massive purchases of Treasury bonds and agency mortgage-backed securities (MBS).

The 10-year Treasury yield has jumped to over 1.5% of late, from just under 1.2% in early August. Right now, the benchmark T-note has almost reached its level last spring, when it soared amid sentiment that faster-growing inflation was returning.

Well, higher inflation has indeed made a resurgence in the Terminator. The consumer price index (CPI) for August was up 5.3% from 12 months earlier. The CPI report for September will be released in two weeks, on October 13, and a number of Wall Street strategists believe it will show inflation remains just as high.

Meanwhile, there is a camp that poops the notion of a long-term inflationary trend. Federal President Jerome Powell and the Biden administration have said the high CPI is transient and is the result of supply bottlenecks and other issues associated with the recovery from the economic plunge linked to the pandemic of last year.

Whatever inflation news is ahead, Lavorgna is not convinced that rising consumer prices will hurt the bond market, which is historically allergic to a booming CPI. He rightly insists that bond investors agree with him. He points out that market expectations for inflation have been stable for months now, and at a not-so-scary 2.4% level. This is break-even inflation, the market’s projected reading of price increases, as guessed by the difference between Inflation-Protected Treasury Securities (TIPS) and conventional Treasury papers.

“The bond market is still not worried about inflation despite continued supply chain disruptions, rising wages and high energy costs,” Lavorgna wrote in a note. Instead, the market is bracing for when the downturn occurs, likely starting in November and ending next summer.

The Fed’s influence in the fixed income market has been considerable since it began buying bonds in the aftermath of the 2008-09 financial crisis, in an effort to keep interest rates low and inject liquidity into the system. This effort intensified when the pandemic hit the economy in early 2020.

In his report, Lavorgna illustrates how broad the Fed’s program has been, noting that the central bank has gobbled up 57% of all tradable Treasury issues since the outbreak of the coronavirus. And the Fed also absorbed almost all of the MBS agency during this period, he adds. This buying frenzy has helped keep mortgage rates low. “It’s no wonder that housing is booming,” he observes.

With the Fed absent from the bond market, he explains, the private sector will be the sole buyer of government papers. The White House’s plans for escalating federal spending will surely inflate the supply of Treasury bonds for sale. Ergo, lower bond prices and, due to the sawtooth nature of fixed income, higher interest rates.

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Tags: 10-year Treasury yield, bonds, breakeven point, CPI, inflation, TIPS


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