News –——

San Franciso, California,

March 22 2021

Inflation

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Mirage or Reality

Since the beginning of 2021, the market’s focus has shifted from when the recovery will start to how fast the economy will recover.

Too fast of a recovery may imply inflationary pressures and test the Federal Reserve’s resolve to keep rates low. We believe that the Fed will face trial by fire in not one, but two distinct waves of inflationary pressures that will manifest over the course of 2021. The recent price action in Treasury bonds shows how the market has started to “price in” the recovery of inflation, which will test the Fed even earlier than we expected.

Over the last two weeks, Treasury bond yields demonstrated a notable bout of volatility, rising 20 basis points to end this week at 1.41%. When we write about volatility, it’s usually in the context of more volatile assets like equities, but this past week the bond market took a big step in digesting the potential economic reflation ahead. Put plainly, bond yields are experiencing some growing pains as we navigate closer to a “post pandemic” world. The rise in the 10-year Treasury yield brings it to a level nearly double what it was just 6 months ago, as seen in the yield curve chart.

US Treasury Yield Curve

Currently:
Inflation expectations are rising, pushing yields higher and steepening the Treasury yield curve to its highest level in 4 years.


Next Few Months:
We think April and May 2021 will show increased inflation due to comparisons with the prior year (April and May 2020) during the depth of the initial COVID-19 shutdown and therefore could be as high as 3%. We think the Federal Reserve is likely to ‘look through’ this data and remain committed to ultra-low rates.


Next Few Quarters:
A second test of the Fed’s resolve will likely take place once the economy returns to normalcy. With “excess savings” of nearly $2T representing substantial pent-up demand and the supply side of the economy having shrunk, 2H 2021 could see more sustained inflationary pressures.


Our View
We think the Federal Reserve is likely to remain supportive of ultra-low rates even during this second wave of inflationary pressures, thereby supporting equities.



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