Bond sell-off underway; is this a problem?
In what looks a prescient call, the Sage of Omaha’s annual letter opined on the recent bond market sell off. This saw 10 year US T-bond yields rise to 1.52%. So far, Buffett has had a good crisis, going into 2020 Berkshire Hathaway held record cash balances.
One reason for the February sell-off is US President Joe Biden’s $1.9trn plan which enters the Senate this week. Americans expect to receive a third stimulus cheque for US$1,400 and $400 per week federal unemployment benefit to 29th August 2022. US government spending rose 40% in the year to December 2020 v 3% gain in government income – with just over $1.3trn spent in just three months.
The December 2020 US government budget shortfall was US143.6bn v $13.3bn in December 2019 – a near 11-fold increase.
According to the National Debt Clock the US debt to GDP ratio stands at 130.5% a level that exceeds the worst post of WW2 (114% ; 1945).
The arrival of US ‘helicopter money’ is funded by increased primary issuance, the sale of new US government bonds. So far, the US Federal Reserve has bought US Treasury bonds with money created electronically. The Fed creates artificial demand for bonds and keeps interest rates low by warehousing its bond purchases. It has $7.36trn in US government bonds in its inventory.
At some point the Fed will start ‘unwinding’, i.e. reducing its balance sheet by the sale of T-bonds, an event likely to move bond yields back up.
But now fiscal profligacy has arrived, the danger is it becomes normalized. Hence inflationary concerns are linked to the size and longevity of the US budget deficit. Excess money supply is being created, that will seep into the real economy. US money supply grew 37.1% to end November 2020 v 5.9% in the year to November 2019.
There are other significant factors supporting 2021 inflation expectations:-
a) Services sector price hikes. The C-19 pandemic has pushed many small businesses to the brink. As economies re-open, restaurants, cinemas, hairdressers, gyms, airlines, transport operators will be hiking prices, regardless of pricing norms, to pay for closures/ higher debt. These hikes will quickly impact inflation gauges.
b) Rising energy commodities including crude oil, natural gas (Brent+47% YoY)
c) Soft US dollar on imported FMCG with weakness v EU/ Asian currencies.
d) Personal Income – in January 2021 US personal income surged 10% v. 0.6% rise in December due to US stimulus cheques and higher unemployment payments.
e) Anecdotal evidence of pent-up demand / consumer willingness to spend (significant cash being held over the C-19 pandemic)
f) Anecdotal evidence of asset market bubbles; Gamestop / Bitcoin/ Tesla Motors where asset prices become disconnected from financial realities are happening with regularity. This is evidence of excess cash in the hands of consumers.
US personal income over C-19
Higher market interest rates, helpful for some
a) A jump in market interest rates/ steepening of the bond yield curve will be welcomed by global banks whose deposit returns have been negligible/ negative for the C-19 period. The rise in bond yields, if sustained and continued could lead to substantial improvement in bank net interest margins (NIM).
iShares US Banks ETF USD (LSE:BNKS)
Investors have started to price in the recovery in US bank earnings over 2021/2022 as impairments/ loan losses decline and consumer balance sheets stabilize.
Whilst UK banks face a similar macro backdrop, a bank earnings recovery is likely during H2 2021. Investors remain concerned over the pace/ quality of the UK recovery as C-19 restrictions are eased. A key issue is what proportion of the 4.7m people on furlough return to work and the impact of higher unemployment on loan losses.
b) Annuity demand/ demand for pension assets
Rising annuity rates, assisted by higher gilt yields are positive for pensioners and pension management companies.
The February move begs the question about the path for gilt yields. Our expectation is the 10 year gilt will soon hit 1% – possibly over March/ April as schools return and recovery hopes are raised. However, post this further adjustment (+0.2%), I expect gilt yields to plateau and move within a range of +/- 0.2%.
The February 2021 global yield jump is a market “turn” with investors saying farewell to negative yields. This suggests confidence in the C-19 vaccine roll-out and the path to economic recovery. There are tangible grounds to expect inflationary forces to strengthen.
However investors should not be fearful of yield normalization as it is essentially a vote of confidence that an economic recovery can withstand higher financial costs. The move should also calm investors nerves as it will reduce the extreme disconnect between negative bond yields (priced for recession) and high equities that have been priced for an economic rebound.