This week is crucial for the Fed because the central bank needs to shape its policy statement in a way that doesn’t roil the markets.
How the bond market trades in front of Wednesday’s Federal Open Market Committee (FOMC) meeting may as well involve wetting one’s finger and putting it in the air to determine its direction.
We’ve heard Fed Chair Jerome Powell speak about current inflationary pressures as “transitory,” and that those upward pressures will subside in the months ahead as global supply lines stabilize. Up until last Friday, the bond market took that narrative to heart, with the Dow and S&P 500 trading to new all-time highs. During this time, value and cyclical stocks were in the lead. The rotation into reopening sectors continues at the expense of growth stocks.
However, Friday’s close saw the yield on the 10-year Treasury note at 1.64% — its highest level in over a year. This was telling for a couple of reasons. First of all, those sectors that are most levered to the economy maintained a broad upward momentum, and a swath of leading cyclical and value stocks were very overbought on a short-term basis. The second, and more important tell, was how the Nasdaq opened lower by 200 points and closed off by only 78 points, even as the bond market closed at that day’s low.
While there are singular arguments as to why bond prices are under pressure, one can make a base case that there are five reasons why bond yields are rising on a collective basis.
– Organic economic growth is accelerating.
– Commodity prices will continue to rise.
– More big spending by Congress on infrastructure and health care will occur.
– Higher wages will lead to higher prices for services.
– The dollar will decline under the weight of the growing national debt.
Let’s address each point. First, producer prices are up. The Producer Price Index for final demand increased 0.5% month over month in February, following a 1.3% increase in January. On a year-over-year basis, the Producer Price Index for final demand was up 2.8%, versus 1.7% in January. That is the largest year-over-year increase since rising 3.1% for the 12 months that ended on Oct. 18.
According to Briefing.com, “The Producer Price Index for final demand, less foods and energy, was up 2.5% versus 2.0% in January. There are a few important takeaways from this report: (1) there were no surprises in the headline numbers, so the stock market could choose to turn a blind eye to it, but (2) there was a sightline to pipeline inflation pressures, as the index for processed goods for intermediate demand rose 2.7% m/m (up 6.6% yr/yr), the largest monthly increase since July 2008.”
The Commodity Research Bureau (CRB) Index traded up and through its pre-pandemic high this past week like hot knife through butter. Shares of the Invesco DB Commodity Index Tracking Fund (DBC) had a strong week, rallied on surging volume and are now challenging a significant overhead resistance level (blue line). If this line is breached, a path higher will open up.
“Forbes” released an article on March 1 called “Biden’s Infrastructure Bill Could Be $2 Trillion Behemoth — Here’s What Goldman Sachs Is Expecting.” Here, the author wrote, “Goldman Sachs laid out their expectations for his forthcoming infrastructure spending initiative — the second phase of his ambitious plan to revitalize the American economy.”
In a research note late Sunday, Goldman Sachs’ analysts said they expect the proposal will be worth at least $2 trillion — and potentially even double that — over the next 10 years based on previous proposals and estimates of how much investment will be necessary to shore up U.S. infrastructure.”
The Associated Press reported that the White House could release the president’s proposal sometime this month. As the $1.9 trillion COVID-19 package is being financed with debt, this massive infrastructure package will also be financed with debt and big tax increases. The chart below does not include the $1.9 trillion in new spending.
Despite the loud rhetoric about low wages, real average hourly earnings increased 3.4% from February 2020 to February 2021. The change in real average hourly earnings combined with an increase of 0.6% in the average workweek produced a 4.1% increase in real average weekly earnings over this period. (www.bls.gov). Sweeping passage of a $15/hour minimum wage at the state level will drive these numbers higher in the months ahead and will factor into the forward inflation data.
According to the Congressional Budget Office, President Biden’s American Rescue Plan Act will further widen the deficit by $1.16 trillion this year, and $528.5 billion in 2022. Fitch placed the U.S. Sovereign Rating of ‘AAA’ on the Negative Outlook list in July 2020. The rating agency noted that, despite a stronger economic recovery, the $1.9 trillion in new deficit spending and proposed future deficit spending puts the prospect of debt stabilization further away as general government debt will rise to 127% of gross domestic product (GDP) this year.
As to the strength of the dollar, it’s a real tug-o-war between the historical response to higher yields and the weight of accelerating debt and deficit spending. The bond market has entered the twilight zone, and it’s really up to the stock market to accept the notion of higher rates as a byproduct of all the components outlined above.
The recent spike in bond yields provided a much-needed boost to the dollar as it came off of an important support level at 90.0. So far, the bull case for a higher dollar is paying off. Stronger economic growth, broader progress in vaccinations, higher Treasury yields, a Fed that is too dovish and short-covering from an overly crowded position by institutions has the greenback pushing higher this month.
“There will be no peace until U.S. 10s reach 2%,” said Kit Juckes, global macro-strategist at Société Générale, in a note. “As yields rise, the dollar rallies, but when yields settle at a new level, the dollar drops back. The pattern probably goes on until bonds find an equilibrium, unlikely before 10-year note yields have a two-handle, judging by taper tantrums and past cycles,” he said. (MarketWatch, March 14, 2021)
What would normally be just another “stay the quantitative easing (QE) course” FOMC Rate Decision event on everyone’s weekly calendar, has become hugely important due to its impact on market sentiment and how the bond vigilantes will react.
There is an underlying feeling that Chairman Jerome Powell better address what the market is worried about, acknowledge that Fed policy is flexible to changing its tone on “transitory” inflation and that the Fed will adjust QE guidelines and respond with the appropriate tools.
In all probability, the yield on the 10-year Treasury note is going move toward 2%, but the question of how it will get there is also important. A gradual movement over the course of a few weeks or longer will likely be generally well received by the stock market. A spike from 1.65% to 2.00% in a matter of days will test the mettle of both the Nasdaq and the tech sector, which accounts for two-thirds of the total stock market capitalization. Let’s hope that Chairman Powell gets it right this time.