(Yahoo!Finance) - Bonds and the dollar...Watch bonds and the dollar, the forgotten stepchildren of a frothy market.
Once upon a time, inflation-wary investors used to telegraph their displeasure by selling Treasury debt, which pushed up yields and the value of the U.S. dollar (one day I’ll explore the fascinating world of interest rate differentials, but that day is not today).
For obvious reasons — primarily massive government stimulus and a central bank that’s been committed to keeping its foot on the monetary policy pedal since at least 2009 — the days of the bond and dollar vigilantes are long gone.
Yet with price pressures entering uncharted territory north of 5%, and if — as Wall Street widely expects, the Federal Reserve moves to pull back on its crisis-era stimulus — these same asset classes are ones investors may want to start paying closer attention to.
To be sure, with some of the Fed’s stimulus being unwound, there will be slightly less liquidity sloshing around in a system that’s lifted major stock benchmarks to record highs.
However, yields and the greenback have not lost their utility as barometers of inflation expectations, which are going through the figurative roof even with growth slowing down. A big cause of that is that the federal government is still expected to pump the economy with fiscal stimulus (though just by how much remains to be seen).
Enter the dollar, which has been mounting an uneven but decisive stealth rally for most of this year against its major counterparts. Bank of America is predicting that “risks to the U.S. dollar are skewed to the upside,” with price action reflecting “Fed messaging around future rate hikes and, related, updates to the inflation outlook, an increasingly pressing matter.”
According to Marc Chandler at Bannockburn Global Forex, the dollar’s year-to-date gains against the yen are closing in on 10%, with investors “pricing in very aggressive tightening by the Federal Reserve. The Bank of Japan will lag behind most high-income countries in the tightening cycle, and the higher U.S. yields are a crucial driver of the greenback's gains against the yen.”
Blame insatiable demand that’s spurred everything from a labor shortage to cargo ships backed up on the West Coast, with Chandler noting that “three main forces are shaping the business and investment climate: Surging energy prices, a dramatic backing up of short-term interest rates in Anglo-American countries, and the persistence of supply chain disruptions.”
Given that the word “transitory” has become both imprecatory and a tongue-in-cheek way to describe stubbornly high prices, equity investors will be parsing exactly when and how the Fed will pull back on its quantitative easing.
And for the reasons outlined above, it’s likely bond bears will be paying even closer attention.
"The Fed will also likely address the significant moves in short-term rates in developed markets around the world — increases that have been very large relative to historical patterns,” according to Eric Stein, CIO of fixed income at Eaton Vance Management.
“It appears that developed-market central banks have been trying to out-hawk each other, given that inflation is proving not to be just transitory but rather a little stickier, with higher prints than expected,” the investor said.
Shorter-dated government debt, which tends to be the most sensitive to inflation has led to “a significant flattening of yield curves globally,” Stein said. “In the U.S., this has led to lower rates at the back end of the curve — still not lower than in other developed markets, but nevertheless a massive curve flattening.”
The combination of higher inflation, a faster-than-expected taper and the curbing of the Fed’s massive balance sheet could “sustain or extend the recent U.S. Treasury curve flattening trend,” according to Bank of America.
All of which suggests that the central bank “has its plate full” trying to manage investor expectations, says Eaton Vance’s Stein.
With risks skewed to the downside for growth and an exuberant market that’s notoriously sensitive to changes in Fed policy, that could end up being the understatement of the year.
By Javier E. David
Editor focused on markets and the economy
