- We anticipate that the US Federal Reserve will need to maintain real bond yields at negative levels for years, in order to help reduce the national debt.
- The appropriate historical parallel is the accord between the Fed and the US Treasury in the 1950s, in which the Fed capped Treasury yields at a level well below the trend rate of GDP growth
- The implication is that the US Treasury and the Fed are likely to coordinate issuance and purchases, in order to engineer low real yields over the coming years. This, in our view, argues for a structural long position.
Near-term market dynamics
In the near term, the yields of US inflation-linked bonds and levels of breakeven inflation (BEI) will be driven largely by the balance of these liquidation flows and the Fed’s purchases. We do not expect new money to be willing to enter the asset class until this dynamic is complete and prices have stabilised.
However, it is apparent to us that the Fed’s asset purchases have already whittled down the supply overhang and that liquidity has materially improved. US linkers are certainly no longer trading as distressed assets.
Long-term factors determining valuations
In the longer term,valuations will be determined by macroeconomic and policy fundamentals.
On the growth side, we expect a severe recession with a lasting impact on the prospects for recovery.
- The COVID-19 crisis is a serious economic shock to a highly leveraged economy already suffering from relatively slow trend growth.
- The negative impact on corporate and household balance sheets will be severe, and the reality is that a large proportion of private sector losses will need to be transferred to the government’s balance sheet.
- Accordingly, we expect the Fed to need to maintain real yields at negative levels for years to help reduce the national debt. This will only be possible if the Fed effectively finances government deficits through Treasury debt purchases to prevent higher issuance from crowding out private sector borrowing.
- The appropriate historical parallel is the accord between the Fed and the Treasury in the 1950s, in which the Fed capped Treasury yields at a level well below the trend GDP growth rate to gradually reduce the national debt as a proportion of GDP.
- The implication is that the Treasury and the Fed are likely to coordinate the maturity profiles of issuance and purchases to engineer low real yields over coming years. This, in our view, argues for a structural long position, or at least a strategy to buy duration on any meaningful falls in price.
So where do we think US inflation-linked bonds should trade in six months’ time?
Market timing is extremely difficult. Liquidations are likely to keep the asset class under pressure for some time. At the same time, once the Fed’s purchases have whittled down the supply overhang, valuations could improve quickly.
However, the Fed has frontloaded its USD 500 billion asset purchase programme, and completed more than half of it in just two weeks.
Tactically, the market may question what happens to US linkers when Fed purchases slow. We could well see a pullback in valuations.
Of course, the answer is that the Fed has had to announce another tranche of quantitative easing (QE) – the deficits require it. Indeed, with the federal deficit over the next year likely to come in at around USD 3 trillion, that will require around USD 60 billion of net Treasury purchases per week (with the gross number being far higher, once we account for the rollover of debt).
The surge in the Fed’s balance sheet to USD 6.5 trillion from USD 4.1 trillion before the COVID crisis reflects the aggressive steps the Fed has taken to smooth financial market functioning. It currently primarily reflects the Fed’s open-ended purchases of US Treasuries and mortgage-backed securities.
The Fed has now committed to continuing with this QE, but it has significantly tapered its purchases of US Treasuries to around USD 10 billion per day currently (from USD 75 billion per day toward the end of March) given the improvement in markets.
What about real yields?
The Fed’s medium-term objective is clear: drive the yields as low and as negative as possible. The economy will need negative real yields for a long time to help work off the debt burden. The nominal yield curve will be anchored by the policy rate at 0 to 25bp, and we anticipate that nominal 10-year yields will trade at between 0.50% and 1.00%.
If 10-year BEIs were to return to 1.40%, real yields would eventually have to trade at between -0.90% and -0.40%. Is this realistic? Well, if the economy slowed in 2018 when 10-year real yields reached 1%, it seems plausible that over the next couple of years, the 10-year US linker yield will need to be held at well below zero.
What about breakeven inflation (BEI)?
A sustained widening of BEIs driven by buyers other than the Fed will likely require some indication that the country is through the worst of the coronavirus epidemic, and that the public health strategy is working.
In other words, investors need to see some light at the end of the tunnel, with the prospect of an economic recovery becoming established. Signs are beginning to emerge after five weeks of confinement as infection and mortality statistics show evidence of slowdown, and indeed we have seen BEIs widen from a low of 0.55% in early March to 1.20% at the time of writing.
Over the next six months, we think 10-year BEIs should return to 1.40%, perhaps 1.50%. To return to 2.0% or higher, we probably need to see the immediate disinflationary impulses of the recession fade, and for concern over longer-term inflation risks to build. That will take some time.
How do we position the US inflation-linked bond portfolio?
The medium-term outlook warrants both an overweight in 10-year BEIs and an overweight in real yields.
At the moment, the weight of Fed purchases of US linkers is dominating the liquidation flows, and US inflation-linked bonds have been outperforming Treasuries both on real yield and BEI. Investor confidence has also been supported by evidence that the impact of COVID-19 is levelling off in countries that implemented strict social distancing measures.
However, we have to be mindful for pullbacks in prices if liquidations of US linkers are seen to be overwhelming Fed purchases in any particular week. In addition, we have to recognise that TIPS BEIs will likely trade with risk assets, which will in turn be driven by economic and COVID-19 data.
Our concern is that the current improvement in sentiment could reverse once it becomes clear that virus containment measures will not be simply lifted in two weeks’ time. Hence we leave room to add to positions on pullbacks.
This is an extract from the inflation-linked bonds quarterly review for second quarter 2020.
Views expressed are those of the Investment Committee of MAQS, as of end-March 2020. Individual portfolio management teams outside of MAQS may hold different views and may make different investment decisions for different clients.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
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