Central banks and governments have responded to the economic havoc caused by Covid-19 with unprecedented levels of both fiscal and monetary stimulus. However, as vaccines are rolled out and economies reopen, continued expansion of fiscal policy (especially in the US where we expect another $4 trillion of stimulus or around 17 per cent of GDP) would confirm our long-held view of arriving fiscal dominance (i.e. when an indebted economy requires monetary support to stay solvent), alongside the likelihood of higher inflation and the increased risk of a taper tantrum in markets.
The quantitative easing deployed following the spring 2020 lockdown is very different from what we saw after the Global Financial Crisis. The primary role of central bank balance sheet expansion this time has been to facilitate fiscal spending rather than to support financial conditions. As part of our analysis, we have mapped out this highly abnormal environment and what its consequences might be.
Composition of nominal yields matters for risk assets
While developed market nominal yields have been rising since August 2020, our analysis shows that it makes a big difference how and why nominal yields go up. According to our tantrum risk assessment, an environment in which real rates are rising and inflation breakevens are falling constitutes a tantrum regime, based on our analysis of similar episodes in 2013 and 2018 when yields spiked.
Indeed, it is the change in composition of the drivers of nominal rate rises in recent weeks that is now reverberating across the markets. After a period of relative stability, real rates have quickly caught up with breakevens, and snapped higher. We see real yields as a key barometer for risky assets. As the chart below shows, environments in which real rate increases surpass changes in inflation breakevens have been tough for risky assets historically. There is also a clear relationship with the behaviour of growth versus value style factors.
What happens next?
We think that, unlike in 2013 and 2018, the current tantrum is not driven by perceived Federal Reserve hawkishness. Instead it is due to the risks emanating from the impending fiscal dominance that will drive a notch-up in cyclical inflation. Yet, even in a fiscal policy-led reflationary environment, with over $280bn outstanding that needs refinancing, the cost of capital matters, and eventually leads to tighter financial conditions that central banks can’t ignore. Lower real yields are the only way for the system to clear, and markets are now testing central banks’ resolve to keep conditions loose.
The Fed's Chairman Powell has been incredibly gentle with policy in this cycle. But how the central bank will use its flexible average inflation targeting (FAIT) framework remains unclear. In the near term, we think verbal interventions from the Fed will continue but, ultimately, we will need credible evidence that the central bank is indeed targeting negative real rates as a policy.
The most potent Fed tool available here is duration extension (i.e. buying bigger chunks of longer-dated bonds). Interestingly, the European Central Bank has more flexibility as it can always expand the Pandemic Emergency Purchase Programme to counter any rise in yields that results from spill-overs from a US-centric tantrum shock.
Volatility is likely to persist in the short term
We are closely monitoring the liquidity picture in US Treasury markets and our trading teams are already noticing signs of stress. These imply that the system is starting to struggle to adjust to the rapid (real-rate driven) rise in nominal rates. The behaviour of the US dollar is also relevant, as any snap-back rally may put further pressure on risky assets as financial conditions tighten further.
In the short term, volatility is likely to persist, and yields may rise further still. However, while further rises in real rates and tightening of financial conditions may be needed before any real action is taken by central banks, we are closer to a turning point than a week ago. Central banks will soon be forced into action (the Reserve Bank of Australia and Bank of Korea have already intervened), potentially pushing real yields down to depressed levels. This should see risky assets and inflation-linked bonds fare particularly well, and bring stability to government bond markets, although the timing will be challenging to call.