By Christine Idzelis
Investors may appear to be shrugging off inflation, but concerns persist.
The 10-year Treasury yield /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +1.04% was trading at 1.46% Friday , drifting lower despite Thursday’s report that the pace of inflation soared for a second month in a row during the economic reopening in the pandemic.
“Inflation is significantly higher than the compensation you’re receiving from being invested in fixed income,” said Eddy Vataru, chief investment officer of Osterweis Capital Management’s total return strategy, in an interview. “Part of the point of being invested in bonds is to preserve purchasing power.”
Fixed-income investors worry about rising inflation because it erodes the value of their existing bonds . While inflation concerns tend to prompt selling, driving up yields, investors are now weighing whether the latest signs of inflation are transitory or persistent as the economy rebounds.
“I would argue that there’s a significant part of it that’s persistent,” Vataru said, “but you won’t know that for months.”
The decline in 10-year yields doesn’t necessarily mean market participants agree with the Fed that inflation is transient, according to Vataru, whose career in fixed-income includes past jobs at hedge fund firm Citadel and asset management giant BlackRock.
Vataru said short positioning in the Treasury market may partly explain the yield dip after Thursday’s report on the consumer-price index showed the cost of living jumped again in May, driving the pace of inflation to a 13-year high of 5%.
Investors with short positions are betting that prices of Treasuries will fall, pushing up yields, according to Vataru. Bond prices and yields move in opposite directions. If rates don’t rise quickly or far enough, these investors may become nervous about losses and exit their bets. Short sellers become buyers when they cover their positions.
“A lot of the buying you’ve seen in the last week or so is probably short covering,” said Vataru. “That’s part of the reason that when you have a move like this you don’t have quite the reaction you otherwise think you would,” he said of the move down Thursday in the 10-year yield.
Still, yields would be higher if there was more consensus that inflation is a persistent problem, according to Vataru. He said he worries about signs of wage inflation in particular, as that can be sticky, and believes inflation will be in the 3% to 5% range “the way we’re tracking right now.”
But Ellen Gaske, lead economist for G-10 economies at PGIM Fixed Income’s global macroeconomic research group, said the yield on the 10-Year Treasury is up from last year and now sits in line with investors’ expectations that inflation is transitory.
“We already saw the reflation trade,” she said. “We already have seen 10-year yields back up, from 50 basis points last summer all the way up to where they are today.”
Gaske explained that rates “quickly reflected” expectations that “we would climb out of this crisis.” She now thinks that by the end of this year the Fed may begin tapering its asset purchases, which along with low interest rates has been part of its accommodative stance.
Gaske earlier this year “pulled forward” her expectations for a rate increase by the Fed to the second half of 2023. Previously, her prediction was for the Fed to raise its benchmark rate in 2024, with the adjustment to her forecast made in the first quarter, because economic momentum appeared strong as COVID-19 vaccinations rolled out.
Gaske expects spikes in inflation will probably be short-lived, partly because prices are being measured against low levels seen last year, and supply-chain bottlenecks that have emerged in the rebound in demand will be worked out. But she said the acceleration of rent-related inflation caught her eye in the latest CPI reading, adding it’s an area she’ll be watching closely for potentially persistent higher costs.
“I think the Fed itself is kind of in a pickle,” said Vataru, as any new characterization by the central bank of inflation as persistent would probably lead to higher rates that would dampen the recovery.
“They almost have to say that it is transitory to kind of keep this going,” he said.
Meanwhile, the Fed’s massive quantitative easing program, or QE, is helping to “stoke the fire” despite no structural issues that point to the U.S. sitting in recession for years to come, according to Vataru. The U.S. isn’t dealing with the same “big debacle” faced in the throes of the 2008 financial crisis, he said, yet monetary and fiscal stimulus continue with stocks near record highs and vaccine rollouts leading to fewer COVID cases domestically and abroad.
“It’s a dangerous potion to have a policy that, in my mind, is really inflationary and then dismiss whatever inflation that comes through the system as transitory,” Vataru said.