Tue Jun 29, 2021
The second quarter of 2021 saw a drop in US Treasury yields, as well as in high-grade tax-free bond yields.
The charts below show the relative movements during the quarter.
The quarter in general was one that saw continued increases in month-over-month inflation but little real reaction in the bond markets. The Federal Reserve has continued to stress that the recent upticks in inflation are “transitory” and that inflation will revert to a more normal level.
Below is the month-over-month Core CPI increases for the past ten years. You can see that the country’s return to a more normalized economy has been accompanied by a pretty good increase in monthly Core CPI numbers.
The next chart shows the year-over-year Core CPI numbers going back ten years.
We are not much worried about the year-over-year numbers. We know that last year’s lower numbers are being replaced by higher numbers this year. For example, Core CPI numbers for March, April, and May 2020 were 0, -0.4, -0.1 respectively, while this year those months produced 0.3, 0.9, 0.7. The bond market knows those negative numbers are being replaced with positive ones and has discounted them accordingly. What we ARE watching is the continued month-over-month numbers and what the trend shows as we enter further into the summer.
The chart below compares Core CPI on a 12-month running basis with ten-year US Treasury yields over the past 5 years.
Reviewing this chart over the past 2 years, we can see that in mid-2019 we witnessed a drop in the US 10-year yield. That was US yields catching up with the lower yields that were prevalent in both Europe and Japan at the time. And then we see the steep drop last year amidst the onset of Covid in the US and around the world. Starting in August of 2020 last year we begin to see the 10-year bond yield move higher, for a variety of reasons: a Democratic victory for the White House, announcements of vaccines in late November, and then the Democratic victory in the Senate after the Georgia runoffs in January. All of this helped to push 10-year bond yields markedly higher off the pandemic lows of last year. And we returned briefly to a positive real interest rate – but it was short-lived, given the thrust up in inflation. There is no question that the rapid advance of inflation is holding real yields (inflation-adjusted yields) hostage.
There will certainly be some reversion to the mean over time. The run rate of inflation should begin to subside – but to what level? Certain commodity prices will react to the ending of supply chain disruptions and come down. But the embedded cost of higher wages is a stickier issue. The bottom line is that we are unsure what the longer-term run rate of core inflation will be. We feel that bond yields will most likely move higher but at a slower pace.
The chart below shows that over the past twenty years trailing core inflation has averaged around 2% but is currently close to 4%.
On the tax-free side, we can see in the first charts the drop in the municipal/Treasury yield ratios. We believe that this has been the result of two thing at work. Rabid demand for munis – even at low yields – has dominated the quarter and indeed the first half of the year. The market has smelled a tax hike from the new administration since the start of the year and has been buying accordingly – even at rates that almost defy economic sense. It’s cheaper to buy a US Treasury or high-grade taxable instrument than to own a tax-free bond. We have seen these buying sprees in the past, and they too revert to the mean over time. The other effect has been a drop in tax-free bond supply. Issuance has fallen in the first half versus what would be a normal first half because overall muni health has been good. Most municipalities have been in very good shape because of higher tax collections of sales taxes, income taxes, and cap gains taxes. At the same time, we know that there has been plenty of federal help for state and local governments in general and for pandemically affected ones in particular. As the economy gets more and more open, we expect some cutbacks in the federal money and municipalities issuing a little more debt at the margin. No doubt the specter of higher taxes will keep any updrift in tax-free yields somewhat in check.
In summary, it was a quarter that saw continued big demand for munis, a sharp rise in inflation (though the Federal Reserve thinks it is temporary), a slight pullback in Treasury yields during the quarter (normal reversion to the mean, in our opinion), and an economy that continues to open up, but with pinches in the supply of many items. We expect a continued slow, upward migration of interest rates as we head into the summer and are adjusting total return portfolios accordingly.
Have a Happy Fourth.
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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.
