Why Did Yields Defy the Fed's Favorite Inflation Gauge?

With already low yields for U.S. Treasuries falling even further on Friday in reaction to hotter-than-expected inflation data, the debt market suggested yet again that the historical norms of finance have been suspended, at least for now. Economic issues may be rolled out to explain this, but they are likely to come up short without a good dose of behavioral factors thrown in.

The much anticipated release of personal consumption expenditures data for April, commonly thought of as the Federal Reserve’s favorite inflation gauge, took place amid an intensifying debate about the nature of the sharp rise in inflation. While forecasts had been lifted after surprisingly hot consumer price index data, an even greater jump in PCE materialized. The annual core rate came in at 3.1%, a notable increase over March’s 1.9%. The consensus expectation had been for 2.9%.

Based on historical experience, bond yields would be expected to rise under these circumstances, both for economic and policy reasons. Facing higher-than-expected inflation, investors would demand greater compensation to maintain the purchasing power of their investments. Meanwhile, the Fed would more likely be expected to consider tightening monetary conditions. Both effects would probably be exaggerated given the very low level of prevailing yields, the exceptionally accommodative monetary policy stance, extremely loose financial conditions and the recent weakening of the dollar.

Yet rather than rise, yields dipped, with the widely monitored 10-year note falling below 1.60% — an outcome even more notable given the following context: The U.S. economy is in strong recovery mode, with 2021 growth projections continuing to migrate higher toward 7% and beyond; many companies are reporting supply bottlenecks and worker shortages; some, including Amazon.com Inc. and McDonald’s Corp., have already announced wage increases; and the pass-through of this to higher prices, according to Warren Buffett and others, has started and is likely to stick.

A number of economic hypotheses may be considered to justify such an anomaly. It could be that despite all the contextual elements, the surge in inflation is both temporary and reversible, requiring that both investors and central banks look beyond the transitory blip data. It may be that it foreshadows a period of economic malaise in which the system is unable support the new growth and price dynamic, pointing to a return to the new normal of low nominal gross domestic product in 2022 and beyond. And it could be that, because of factors beyond all this, the Fed is both willing and able to use unconventional monetary tools to further distort markets, including driving an even greater disconnect between fundamentals and market prices.

Markets have certainly been conditioned, again and again in recent years, to think that the Fed will maintain ultra-loose monetary policy almost regardless of what’s going on in the economy. Underpinning this is an undeniable evolution in two powerful central bank instruments, both of which have been consistently reinforced by the forward guidance associated with regular remarks from central bank officials. Namely, the policy rates mantra has evolved from low, to low for long, to low for longer and, now, low forever; and large-scale asset purchases that once had sequential numbers (such as QE2 and QE3) have evolved into QE infinity and seem to preclude even talking about a possible small reduction in the $120 billion of monthly bond purchases.

No wonder stocks rallied on Friday. Higher inflation tolerated easily by the Fed means that greater pricing power for companies can bolster profitability when demand is picking up significantly and loose financial conditions continue to subsidize both genuine financial transactions and a range of financial engineering. The more this sweet spot is seen to persist, the more some investors are pushed to take even greater risks and the more likely the resurrection of highly speculative trading and investing (witness the return of the Reddit short squeeze impacting shares of AMC Entertainment Holdings Inc.). It also increases the risk of gradually eroding broad-based public and academic support for public infrastructure programs that are central to efficient, durable and sustainable real investments as opposed to financial ones.  

Friday’s price action after the release of the PCE data was not an example of markets acting irrationally. Instead, it was yet another reminder that traders and investors have been repeatedly conditioned, and strongly believe, that an incredibly favorable liquidity paradigm will persist regardless of fundamentals. They need strong unambiguous evidence that this is not the case before better aligning the three big determiners of portfolio health — expected returns, volatility and correlations — with economic reality. That, in turn, requires a Fed that understands and monitors better the excessive risk-taking happening in the non-banking segment, is more sensitive to the rising threat of future financial instability and is willing to incur some short-term discomfort to minimize the specter of a future of far greater financial volatility.

Until this happens, unnecessary financial risks are building that could eventually undermine longer-term economic prosperity. Meanwhile, monetary policy is yielding insufficient room for booming private and public consumption and rising corporate capital expenditures that are key to bolstering future productivity and growth. Rebalancing the country’s macroeconomic policy mix away from ultra-loose monetary policy in favor of growth-enhancing fiscal and structural reform policies is an urgent necessity not just for greater financial stability but also for economic and social well-being.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."

©2021 Bloomberg L.P.

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