The primary themes impacting the yields of US Treasuries and the pricing of future levels of inflation (via breakeven inflation rates (BEIs)) have changed little in the last few months. They continue to generate a range-trading environment for US Treasury bonds and TIPS.
1) The US economy appears to have closed its output and employment gaps, while growth for the next two years looks set to exceed potential (due to resurgent business investment and fiscal stimulus).
As a result, there are tentative signs that underlying inflation pressures are building. Although recent readings have been weak, core inflation is already close to the Federal Reserve’s target and looks set to overshoot it slightly over the next two years.
2) The Federal Reserve (Fed) is proceeding with the removal of extraordinary accommodation via a steady drawdown in its holdings of government bonds and mortgage-backed securities (MBS) and through continued ‘gradual’ increases in its policy rates.
In theory, this should allow for a rise in real yields and a gradual normalisation of term premia.
3) Net supply of Treasuries is increasing markedly to fund both the administration’s debt-financed tax cuts and new spending plans (enacted in December 2017 and February 2018), and the roll-off of the Fed’s security holdings.
In theory, this should raise the real yield term premium on Treasury debt and may begin to ‘crowd out’ private credit creation.
4) Investors are adjusting to new leadership at the Fed. To the disappointment of TIPS investors, chair Jerome Powell has rejected calls for a more permissive stance towards inflation overshoots and dismissed price-level-path targeting as a realistic policy approach in the current economic environment.
Mr. Powell has adopted a cautious approach to policy normalisation, stressing the need for gradualism in the face of uncertainties over inflation and the location of the ‘neutral’ policy rate. This gradualism, combined with limited tolerance of any inflation overshoot, has kept volatility, breakevens and term premia contained.
5) During the summer of 2018, the US administration further advanced its “America First” agenda by enacting tariffs on imports from countries with whom it judges current trade agreements are not “balanced and reciprocal” and by seeking renegotiation of those agreements.
The US continued to negotiate with Canada and Mexico on a replacement trade deal for NAFTA – eventually reaching agreement on 30 September. Simultaneously, the administration enacted tariffs on USD 250 billion of imports from China and threatened even broader tariffs if China did not adjust its practices on market access and forced transfers (and alleged theft) of intellectual property. Remarkably, equity and fixed-income markets appeared to take escalation of the trade tensions in their stride.
6) Abroad, the formation of a coalition populist government in Italy has reignited market stress in the single currency area.
Investors and credit rating agencies have highlighted risks to Italian fiscal sustainability and raised the spectre of an Italian debt restructuring and even a euro exit. Headline risks have generated market volatility as investors have sought safety in the US dollar and US Treasuries.
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