From V-shaped recovery to bond vigilantes

Putnam Fixed Income team, 04/15/21

  • The U.S. Treasury yield curve has steepened in response to no rate hike projections through 2023.
  • The Fed may start tapering its bond-buying program as soon as the first half of 2022 but refrain from raising its policy rate.
  • We could see an initial V-shaped recovery in the jobs market with sustainable re-openings.

Investors have been mulling the Federal Reserve’s monetary policy on the heels of President Biden’s $1.9 trillion stimulus package. The Fed remains dovish because of the continued slack in the labor market. But the bond markets aren’t convinced dovishness is appropriate.

Keeping an eye on labor markets

The Fed’s new policy framework has two objectives: full employment and inflation at 2% over the long term. Key Federal Open Market Committee members have said that progress is needed in the labor market as a precondition for tightening. The Fed believes its inflation target can be met only when employment approaches pre-Covid-19 levels. So, the central bank will likely signal a policy tightening once the economy can approach maximum employment and stable prices.

The current U.S. aggregate employment is about 8.5 million fewer people than its pre-Covid-19 level. In non-farm private payrolls, goods employment is about 1 million and services jobs are about 7.5 million below their pre-pandemic levels. The other labor market variable the Fed is watching is wage inflation. The Fed believes a sustainable rise in inflation will come with higher wage gains. These dynamics will play out with declining wage inflation.

Inflation chart

We might see a V-shaped recovery in job gains during the transition phase of re-openings. We expect these payroll gains to moderate after the acceleration phase as aggregate employment starts to approach pre-Covid-19 levels. The pandemic changed the way we do business and live our lives. Some of these changes will stay, slowing the pace of job gains. In addition, some jobs created during the pandemic are likely to be lost during the normalization phase.

Fed likely to open door to bond taper in 2022

It is possible the Fed will announce plans to slow the pace of asset purchases during the V-shaped recovery stage. FOMC members may signal the time frame to start tapering as they gain confidence in the strength of the economy. Based on earlier policy statements, there will be a period of around six months between the announcement and when the central bank starts paring back its bond-buying stimulus efforts.

We believe the Fed may announce tapering in the third or fourth quarter of 2021 if Covid-19 cases don’t take a turn for the worse and economic activity improves. Tapering of asset purchases —  a form of monetary tightening — could start as soon as the first half of 2022. Even the announcement of taper plans is a tightening, as financial markets move ahead of the Fed. Traditional rate hikes might take time, as improvements in the labor market is likely to come with lower wage inflation.

Wage inflation has potential to surprise to the upside, however. Labor market participation dropped with the pandemic and is yet to show any sign of improvement. If generous unemployment benefits prevent low-wage earners from going back to the labor market, participation in the labor market may stay low and wage inflation might stay relatively high.

While we expect the expanded unemployment benefit programs to be temporary, there is a risk the redistribution programs that incorporate some flavors of this will remain. In some sectors, wages would rise during the adjustment phase. Even though the wage inflation should come down with the normalization of life, this development can slow down the process, contributing to higher-than-expected wage inflation.

Will the Fed raise rates?

As for raising the policy rate, the Fed may stay put until there is substantial progress in the labor market. The Treasury yield curve has steepened in response to no hike projections through 2023. The Fed can control the front-end of the curve but not the back end. The Fed’s March dot plot — which the central bank uses to signal its outlook for the path of interest rates — indicated no rate increases through 2022 or 2023 by a majority of FOMC members. However, financial markets have not been patient. The economic outlook has improved, and fiscal discipline seems to have declined. Market players think it is time for the Fed to signal a tightening path.

Bond vigilantes seem to be emerging in the Treasury market, attempting to add a fiscal premium to the curve.

When the median dot did not go up at the March meeting, investors responded by selling Treasuries and driving yields higher. Bond vigilantes seem to be emerging in the Treasury market, attempting to add a fiscal premium to the curve. The U.S. rates market is not used to this kind of premium, which is more typical for emerging-market rates or assets that come with extra risk. Rising inflation break-evens seem to be just a reflection of this.

When the policy mix is not appropriate, investors generally remain doubtful, raising inflation expectations and demanding further compensation. Sustainably higher inflation may not arrive, but inflation expectations can rise until restrictive policy is in sight.