A bad week for inflation sceptics
Senior Fixed Income Strategist
Summary: We are about to close a pivotal week for inflation sceptics. The hearing of Janet Yellen before the Senate Finance Committee, the 10-year TIPS auction and the rise in the Breakeven rate are suggesting that inflation is on the rise. Bondholders of nominal Treasuries will suffer large losses as the yield curve continues to steepen. We believe that it has arrived the time to consider coupon-income and Inflation hedging.
It is becoming more apparent that inflation sceptics might need to rethink their strategy, or at least to consider to hedge against inflation.
Yesterday the US Treasury issued 10-year Treasury Inflation-Protected Securities (TIPS) at the lowest yield in the US auction history: -0.987%. After this auction, the 10-year breakeven rate rose to 2.18%, a two year high.
Inflation sceptics might not be impressed by this move; however, breakeven rates are not the only indicators proving that more inflation might rise. While the 2s10s part of the US yield curve is failing to steepen beyond 100bps, the amount of money supply (M1) in the economy is unprecedented, suggesting that spending should rise impacting inflation directly.
The $1.9 trillion Covid relief plan is also playing a big part in the reflation story.
Suppose one doesn't believe that the fiscal stimulus will be enough to stimulate inflation. Still, it should pose some questions around one's strategy over nominal US Treasury bonds.
Even if inflation does not go higher, nominal yields will rise anyway in light of higher government bonds' supply to finance fiscal spending. Yesterday, the US Treasury announced the issuance of 2-, 5- and 7-year notes for a total of $183bn next week. And it is just the beginning. US Treasury Secretary nominee Janet Yellen said before the Senate Finance Committee this week that she will look at the possibility to issue ultra-long government bonds. Even though this was something that her predecessors failed to do, it doesn't mean that there is no probability that it will happen in the future. It implies that Treasury bond issuance might become particularly heavy on the long-term side, and the yield curve will steepen further, inferring more pain on investors.
Once the spread between the 10- and 2- year Treasuries break above 100bps, it will most likely find resistance around 120bps. We already know by now that the front part of the US yield curve is not moving, thus only long term rates will suffer this loss. A 20bps movement in 10 year Treasuries corresponds to around 2% loss for bondholders, while on 30-year Treasuries it will be already about 5%.
The only solution? Seeking coupon income and inflation hedging.
Percentage loss/gain according to a movement in yield
Latest Market Insights
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.