Equity markets rebounded nicely for most of February but hit a wall as the Treasury market took center stage. The S&P finished up +2.76% but sold off over 3% in the last two trading sessions as interest rates soared. While equity markets remain positive and “risk-on” days seem prevalent, the sharp turn in rates has made the bond market interesting again.
There has been no place to hide in the bond market as rates continue to be under pressure in 2021. The bell-weather US 10-year Treasury note rose from 1.067% to 1.407% during the month, briefly topping 1.60% on February 25th. While the reflation story remains positive for the US, fears of inflation have been the main catalyst for the bond rout.
The unprecedented amount of monetary and fiscal stimulus being pushed into the economy is raising inflation fears as liquidity is abundant. As we hopefully begin to emerge from the global pandemic, an ongoing question will be whether this is an inflationary environment or more of a reflationary story. While core PCE for last quarter and CPI last month remained stable, the ISM prices paid index and PPI readings were sharply higher. Unit labor costs also rebounded and surveys on inflation expectations were elevated.
The Fed made it clear in February that they are not concerned about inflation. Growing the economy to a pre-pandemic level and getting people working again is their main goal right now. FOMC Chairman Powell spoke before the Senate banking committee mid-month and stated “the economy is a long way from our employment and inflation goals”. His speech at this semi-annual meeting, along with other Fed governor speeches, reinforced continued bond purchases “at least at this level” along with a near-zero fed funds rate. Powell also made the case that much of the inflation uptick may be transitory and a result of added liquidity and a reflation from our darkest period of the pandemic. As the economic backdrop becomes more optimistic, the yield curve continues to steepen. While the Fed doesn’t seem phased about longer-term rates rising, global central bankers are sounding alarms. The price action in the US market is causing global rates to increase as well.
Volatility is up in major markets and technical factors have been important, particularly in the bond market. The US Treasury has pushed a great deal of liquidity over to the Federal Reserve which has compressed T-bill and repurchase agreement rates nearly to zero. The question is whether this money finds its way into longer-term securities. Treasury auctions showed some signs of weakness during the monthly refunding auctions. The highlight was the 7-year auction that “tailed” over 4 basis points to its advertised price in the marketplace. Many participants viewed this as pull back from other central banks in our auctions (China?).
Corporate bonds and municipal bonds were not spared in the sell-off. Corporate bonds had slightly worse performance during February than Treasuries despite demand for any new issue. Risk premiums on bonds remain at very low levels. Municipals, which had defied gravity for months, sold off 1.59% from very expensive relative valuations. Emerging market debt sold off modestly, while high yield was able to stay slightly positive with equity markets.
A focus on duration in fixed income markets is important. In the broad spectrum of investment grade securities, 3-5 year investment grade securities fell only -0.57%, while longer maturities (10+ years) fell over -4.0% during February.
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