When the Federal Reserve stepped in to support the world’s largest debt market in March, fixed income investors were relieved. But in successfully staving off a more pronounced financial crisis, the Fed has further distorted markets, they say, overwhelming the once-reliable signals that bonds used to give about the path of the economy and inflation.
Over the past two months, the Fed has snapped up roughly $1.5tn of Treasuries and another $600bn or so of agency mortgage-backed securities as part of its pledge to buy an unlimited quantity of government debt. According to JPMorgan, the total of the Fed’s bond-buying in just a handful of weeks is in line with what the Fed purchased during the nearly three-year period covering its second and third rounds of quantitative easing after the financial crisis.
The result is that no matter what the likely path of inflation, no matter how fierce or mild the threat to global economic health, bonds are going nowhere fast.
“There’s so much QE, it waters down your conviction on what the bond market is telling you,” said David Vickers, a multi-asset portfolio manager at Russell Investments.
For market participants, these muted signals have implications far beyond the Treasury market. Government bond yields in the US and other big economies reflect the return investors can expect to earn without taking risk, in the process serving as “the foundation on which you build every asset”, according to Rick Rieder, BlackRock’s chief investment officer of global fixed income. If Treasury yields are distorted, so too are prices for stocks, corporate bonds and just about everything else, some analysts argue.
These arguments have become commonplace since the massive stimulus launched in the wake of the last financial crisis. But the unprecedented central bank interventions in response to coronavirus have given them new urgency.
As Gennadiy Goldberg, senior US rates strategist at TD Securities, says, the Fed’s interventions “make you think twice about rules of thumb”.
Treasury yields have touched fresh lows since March, as bond prices have risen, despite the Treasury department flooding the market with a record-breaking amount of new debt to fund the Covid-19 relief packages. Benchmark 10-year bonds now yield close to their historic low, at 0.7 per cent — a more than 1 percentage point slide since the beginning of the year. Two-year Treasury yields recently touched new lows of 0.13 per cent, having yielded 1.6 per cent in January.
“The levels that we are looking at in yields are being manufactured by the Fed with a goal of keeping financial conditions easy,” said Jim Caron, senior portfolio manager for global fixed income at Morgan Stanley Investment Management, adding that the information that investors can glean from yields has “eroded” as the central bank has ramped up its purchases.
“The more you interfere with markets, the less signalling you will get,” he said.
Investors tend to keep a close eye on government bonds, which act as an early-warning system for inflation ahead. Because interest payments on bonds are fixed, higher inflation erodes the real return that holders earn. Yields typically rise in this environment as investors step away from the asset class.
Inflation is now suppressed, with many investors increasingly worried about deflation. A large acceleration in prices, to, say 5 per cent a year, could be enough to hit bonds, investors and analysts say. But barring that, yields are pinned lower for the time being, given the relentless buying by central banks.
Mr Caron argues the Fed’s interventions are distorting market measures of inflation expectations too. The 10-year “break-even” inflation rate, which is derived from prices of inflation-protected government securities, currently sits at 1.1 per cent — a level far below the Fed’s 2 per cent target.
While Mr Caron acknowledges the near-term economic backdrop is set to be a dismal one, he said he is hesitant to read too much into this metric, questioning if it is an “accurate reflection of the future or if it is the Fed just buying [inflation-linked securities]”.
Kristina Hooper, chief global market strategist at Invesco, sees distortions created by the Fed as well, but argues that right now, that is a secondary concern. “The Fed is in triage mode,” she said. “It can’t be focused on those unintended consequences when the task at hand is so critical.”
Investors caution against disregarding the bond market’s signalling effects altogether, especially given the enormous economic toll of the pandemic.
“Clearly there is going to be some level of distortion given the unprecedented amount of Treasury purchases from the Fed, but broadly speaking, it aligns with the slow growth, low inflation outlook that persists in an environment like this,” said Subadra Rajappa, head of US rates strategy at Société Générale.
At the most recent meeting on monetary policy, Fed chairman Jay Powell painted a gloomy picture of what is in store for the US economy, warning of “considerable risks to the economic outlook over the medium term”. So far, millions are out of work.
When the economy eventually finds its footing and inflation picks up, Luca Paolini, chief strategist at Pictet Asset Management, says he expects yields to rise, especially as the Fed withdraws some of its emergency measures.
Yet, the central bank may struggle to do so, warns Gregory Peters, a senior portfolio manager at PGIM Fixed Income, given how far-reaching its interventions have become and how challenging it has been in the decade since the global financial crisis to wind down its previous support.
“If an exit was difficult before, I think it is close to impossible now,” he said.