In a Holding Pattern
In a television interview this morning, Federal Reserve Vice Chairman Richard Clarida reaffirmed the Fed’s dovish policy shift concerning setting monetary policy in a post-COVID environment. The Fed will likely keep rates low for the foreseeable future until inflation rises above 2% on a sustainable basis and U.S. employment reaches maximum strength. With respect to the inflation outlook, both economic forecasts (Figure 1) and market-based indicators (Figure 2) do not anticipate inflation meeting the Fed’s thresholds for tighter policy anytime soon or further out in the future even as both don’t expect an outright return to deflation that would threaten economic growth and capital market conditions.
Figure 1 – Economists Anticipate < 2% Core Inflation Over the Next Two Years
Figure 2 – Break-Even Rates Priced Between US TIPS and Nominal Treasuries Have Pulled Back from Recent Highs While 10-Year Treasury Yields Remain in a Tight Range
Source: Bloomberg through 9/22/2020
However, real interest rates (based on the Constant Maturity 10-Year Curve) have stopped dropping and appear to have hit a floor around negative 1%, suggesting that the bond market doesn’t expect inflation to move meaningfully higher even with rates near 0% for much of the short-to-intermediate part of the curve. This could explain the recent weakness in precious metals as gold spot prices have pulled back after having reached $2000/ounce. Figure 3 shows this tight relationship between trends in real interest rates versus gold prices – the tight correlation suggests that real rates would need to drop deeper into negative territory for the gold rally to continue.
Figure 3 – Gold Price Moves with Real Interest Rate Trends – A Stall in the Latter Could Create Pressure on the Former
After hitting a post-COVID low earlier in the quarter, the U.S. dollar has strengthened (Figure 4), especially against the euro which peaked at 1.19 EUR/USD and currently trades near 1.16/1.17). The relative strength/weakness of the U.S. dollar has served as ‘Ground Zero’ for global financial and trading conditions; the post-COVID weakness in the U.S. dollar has helped catalyze the reflation trade rally in stocks and commodities.
Figure 4 – Keep an Eye on US Dollar Strength Putting Pressure on the Global Reflation Trade
Source: Bloomberg through 9/22/2020
So, we appear to be in a holding pattern with respect to Fed policy, real interest rate trends, and global reflation, at least until the outcome of November’s US election, which may give us clarity on the nature and make-up of the next round of pandemic aid/stimulus. In the interim, we would suggest keeping an eye on inflation expectations implied by TIPS/U.S. Treasury break-even rates, precious metal price activity, and corporate credit conditions.
The recent widening in corporate credit spreads do not necessarily indicate credit stress and tightening financial conditions but may be more influenced by a strong year-to-date issuance of corporate debt (especially high yield debt which is expected to surpass 2012 record issuance). U.S. Treasury Secretary Steve Mnuchin also indicated that half of the CARES Act funding allocation for secondary capital market support should be reallocated to other relief needs, suggesting that U.S. Treasury would like to wind down the taxpayer-backed vehicles supporting the Fed’s emergency lending facilities. These facilities are slated to expire at the end of the year but would likely be extended in the event capital market conditions worsen (the new ‘Powell Put’ focused on supporting corporate credit rather than equities).
Equity market volatility may stay elevated around investor anxiety stemming from the U.S. election, China trade relations, UK Hard BREXIT, and a pickup in equity market volatility will likely be felt in the riskier areas of the credit markets as well as commodity price action. However, the longer-term debate over whether the global economy will experience a post-COVID recovery will likely keep the global reflation trade in a holding pattern for the time being. For now, the recent weakness in corporate credit could afford an opportunity to add a bit of extra yield assuming the Fed/US Treasury still have Corporate America’s back.
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By: Benjamin Lavine