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The benchmark 10-year Treasury bond yield opened at 1.31% Monday morning, and is currently siting at 1.29% as of this writing.
That may have come as a surprise to some. Powell confirmed that the Fed is ready to begin tapering the rolling back of its bond-buying program by the end of the year. That means that there will soon be less demand for government bonds and government-backed bonds.
Basic economics teaches us that a smaller demand for bonds, other things being equal, pushes bond yields higher, not lower.
What are markets missing? Perhaps, nothing. Markets are discounting mechanisms. They discount good and bad news ahead of time. That may very well be the case this time around.
Markets pushed up bond yields ahead of the Fed chair’s speech, and then gave up some once they heard the news, which was slightly better than expected: tapering will be gradual, and dependent on how the coronavirus spread unfolds.
There’s another, more important reason for the yield drop, in my opinion: the Fed chair supporting his view that the spike of inflation in recent months is transitory, rather than persistent.
For instance, Powell claimed that inflation is concentrated on a narrow group of goods and services affected by the reopening of the economy. If that’s the case, inflation will taper off once the economy recovers from the pandemic, and consumer demand is balanced between commodities and services.
Here’s a quote from the Fed chair’s speech:
“The spike in inflation is so far largely the product of a relatively narrow group of goods and services that have been directly affected by the pandemic and the reopening of the economy. Durable goods alone contributed about one percentage point to the latest 12 month measures of headline and core inflation. Energy prices, which rebounded with the strong recovery, added another 0.8 percentage point to headline inflation, and from long experience, we expect the inflation effects of these increases to be transitory.
“In addition, some prices — for example, for hotel rooms and airplane tickets — declined sharply during the recession and have now moved back up close to pre-pandemic levels. The 12-month window we use in computing inflation now captures the rebound in prices but not the initial decline, temporarily elevating reported inflation. These effects, which are adding a few tenths to measured inflation, should wash out over time.”
The Fed chief also delved into indicators that monitor inflationary expectations, mentioning that “these measures today are at levels broadly consistent with our [2%] objective.”
That’s music to the ears of bond traders. Inflationary expectations are the most crucial factor in determining long-term bond yields, as bond investors must factor future inflation into valuing long-term fixed assets.
The bottom line: Powell did a great job convincing capital markets that inflation is transitory, helping push bond yields lower, at least for now.
Only time will tell whether his views are correct.
