Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Weak Treasury auctions tell us that inflation risk is real
Althea Spinozzi
Head of Fixed Income Strategy
Summary: This week's 10 and 30-year Treasury auctions priced weaker as inflation expectations rise sensibly with the five-year forward inflation swap breaking overhead resistance. Consumer prices might already be higher than CPI's figures because the basket of goods that people need today is much more expensive than one year ago. We expect the US yield curve to continue to steepen with long term maturities leading the way.
Behind the noise of the US elections and a fiscal stimulus package, the bond market is giving meaningful signs that something is changing.
Trump’s tweets this week have eclipsed the 10-year, and 30-year Treasury auctions, which we believe have something to say amid the confusion created by the US election.
Ten year Treasuries on Wednesday priced in line with the auction's the pre-sale yield. However, demand was driven by indirect bidders while direct bidders' demand fell significantly. By the end of the day, the 10-year Treasury yield closed a couple of basis points higher than where it priced earlier in the day.
Demand at yesterday's 30-year Treasury reopening wasn't as strong as expected as the notes awarded a yield of 1.678% which is a basis point higher than pre-sale indications. Furthermore, the bid-to-cover, which is a measure of demand, was slightly weaker than the one of last month.
What is happening is that as Biden's polling lead over Trump grows, the market is adjusting inflation expectation. Indeed in the past few days, we have seen inflation indicators breaking meaningful levels.
The 5-year 5-year forward inflation expectation has broken its resistance line, reaching levels previously seen last November: At the same time, we are also seeing the US 10 year Breakeven and the Consumer Price Index moving higher:
We believe that there are signs that inflation might be already higher than what the index shows. Remember, CPI is a biased figured, depending on which basket of assets you are looking at. Consumers today might be needing and buying different things from years ago. This is particularly true this year as prices rose for goods that are necessary during the Covid-19 pandemic.
We have analyzed data coming from the US Bureau of Labor and Statistics in order to understand how the coronavirus pandemic is affecting inflation. We found out that inflation has increased exactly for that stuff that people need today, such as house appliances, the food at home and rent of primary residence. At the same time, we see the price of stuff we don't need any longer dropped such as airline fares, public transportation and lodging away from home.
In conclusion, we believe that investors should look beyond the noise of the US election to understand why the US yield curve continues its steepening pattern. At this point in time, it is crucial to accept inflation risk and to position accordingly.
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