By James Picerno, Director of Analytics
The Federal Reserve reaffirmed its ultra-dovish monetary policy in this week’s FOMC meeting and the futures market continues to price the odds of a rate hike at 0% deep into 2021. But real-world conditions in government bond trading are hinting, if only on the margins, that a post zero-forever world may not be forever after all.
Exhibit A is the gradual but persistent steepening in the Treasury yield curve over the past year-plus. The current 10-year/2-year spread, at +79 basis points (Dec. 16), is still unusually low by historical standards. But the spread has also been trending higher, in fits and starts, for a year-and-a-half and is now at a three-year high.
A steepening yield curve is traditionally viewed as a market forecast for higher inflation and/or strong economic activity. By some accounts, both conditions apply. That may sound improbable at the moment, but as vaccines start to roll out across the US it’s getting easier to envision a healing process in 2021 for the economy. The repair and recovery process is showing up in GDP forecasts for the fourth quarter and in Q1 estimates for 2021.
Treasury market inflation expectations are also rising. The implied inflation outlook, based on the yield spread for the 10-year nominal and inflation-indexed rates, is roughly 1.9% — the highest since May 2019.
It’s notable that the Federal Reserve this week is also thinking positively, albeit on the margins. The central bank’s new forecast for US GDP growth in 2021 was revised up to 4.2% from 4.0%. Then again, vaccines won’t be widely distributed until the spring at the earliest and so the Covid-19 blowback will likely get worse before it gets better.
Of all the economic risks that are weighing on the economy, the worrisome trend in jobless claims is at the top of the list, with new filings for unemployment benefits in the first week of December jumping to a three-month high of 853,000. Until claims fall sharply from current levels, there is a risk that the ongoing loss of employment will throw the US into a new recession.
It’s not surprising, then, that the Treasury market is hedging its bets. The yield curve is increasingly bullish on 2021’s prospects. But the benchmark 10-year rate, by contrast, is currently just 0.92%, which is far below the pre-pandemic 1.5%-2.0% range — a sign that the crowd's appetite for safety remains elevated.
Deciding which side wins will depend on the incoming data. A sliding trend in the current sky-high jobless claims reports will be an early sign that the pandemic’s grip is finally loosening. Unfortunately, for now winter darkness still prevails.
(An earlier version of this article first appeared at The Capital Spectator.com on December 16, 2020.)