All of a sudden, it seems, the long-placid bond market has lurched into action. Prices have dropped, and as is the way of bond math, yields have risen. The 10-year treasury note, for instance, has seen its yield more than double, rising from 0.7 percent last fall toward 1.75 percent recently.
Much of what seems to have upset bond investors has been evident for some time now. But some sources of concern are relatively new, particularly the spending plans of the Biden administration. The combination of existing and new concerns has hit the bond markets with what might be described as a four-punch combination.
Bond markets were already in an untenable state in 2020. With short-term interest rates driven down to about zero, and with active bond buying on financial markets by the Federal Reserve (Fed), bond yields had already fallen below the rate of inflation. Without some major policy push to drive rates and yields down even farther (and so prices up higher) holding bonds was already a losing proposition. Meanwhile, the Fed and other central banks showed little appetite for adding still more support to markets than they already were. In other words, bonds were an unattractive investment unless the unlikely happened. To be sure, less credit-worthy bonds continued to offer yields above the rate of inflation, but the risk involved in buying them recommended buying other investments first. In such an environment, anything in the least bit discouraging could tip the flow of monies away from bonds.
Investors understand that the Fed’s ongoing support of liquidity could always cut two ways. It sustains demand for financial assets, including bonds, but in the longer term, and more fundamentally, a surplus of liquidity could always trigger accelerating inflation, which would erode the real value of the interest earned on bonds. As long as the Covid pandemic raged, investors thought little about inflation, especially because the economy had enjoyed a long stretch of low inflation before the virus arrived. But with vaccinations increasing and a full or almost-full economic re-opening on the horizon, what had been secondary concerns about inflation have become a larger element in the calculations of bond investors. Even though Fed Chairman Jay Powell has voiced assurances that inflation was not a concern, investors, confident that the economy will grow strongly in 2021 and 2022, see the possibility of economic overheating and thus do worry about inflationary pressures.
There is now concrete evidence of rising inflation. Consumer prices in the opening months of 2021 rose at a 4.5 percent annual rate, far above the 2.0 percent averaged for the prior ten years. Producer prices, after showing no increases (on balance) for years, have risen at a 5 percent annual pace since last June. Commodity prices also have risen sharply since last year. Copper prices, for example, jumped some 25 percent. Oil prices are up 50 percent. The broad commodity price index has risen 30 percent.
The most recent development arises from the deteriorating picture of federal finances. Concerns here have grown markedly since the Presidential election. There is little doubt that federal finances had already taken a bad turn long before the election last November. Tax cuts in 2017 had already greatly enlarged budget deficits, and spending to bolster the economy during the pandemic had also added to the flow of red ink, which official sources projected would reach $2.3 trillion in 2021, some 10.3 percent of GDP, which is well above historic norms of about 3 percent. Now, with an additional $1.9 trillion in spending from President Biden’s Covid relief package, the 2021 deficit looks likely to rise to over $4 trillion, almost 18 percent of GDP.
Especially because the economy is expected to surge with the projected further re-opening of economic activity, many economists, even Democratic ones like Lawrence Summers, have warned that this additional spending is excessive and could lead to economic overheating, with its implied threat of inflation. Considering that the White House is also talking about spending heavily on infrastructure, including elements of the Green New Deal, the prospect of overstimulating and overheating the economy have only increased, and with it, a growing prospect of inflationary pressure. If this were not enough to frighten bond investors, the flood tide of red ink implies that enormous federal borrowing will create a huge supply of new debt and exert inevitable downward pressure on bond prices.
To the investor, circumstances suggest avoiding bonds –– but there is a silver lining. The more that bond yields rise, the better they can perform their traditional role of providing income to an investment portfolio. Retirees have long used a large bond allocation in their portfolio to provide the income they need once they are no longer receiving a paycheck. In preparation, investors nearing retirement have gone into bonds. But as yields fell, bonds failed to function in this traditional way. ith yields now on the rise, bonds may once again fulfill this role.