Markets follow Fed’s example and dismiss rise in inflation as ‘transitory’
Markets appear to have bought into the US Federal Reserve’s view that the recent increase in inflation is “transitory” and the result of reopening economies, which will gradually fade as activity begins to normalise.
However, the plunge in longer-dated Treasury yields to below 1.4 per cent, from above 1.7 per cent, is the most graphic manifestation of this correction in “reflation trade”. This has resulted in the flattening yield curve catching investors off-guard and causing a short squeeze in Treasury futures positions that intensified the drop in yields.
Other technical reasons may also have been at play, among them temporarily falling Treasury supply, with the General Account at the Fed drawn down steadily to about $750 billion at the end of June, from a balance of above $1.8 trillion last July. There have also been developments in money markets, where the Fed’s reverse repo programme is raking in hundreds of billions of dollars – hitting almost $1tn at the end of the second quarter.
The banking sector’s huge liquidity balances recycled at the Fed still pose a threat to price stability, particularly if banks start lending again to the real economy. But if all the monetary largesse of central banks stays with lenders, the inflationary threat is muted
– or even absent – as the additional liquidity will not reach the real economy. Should the stance of lenders change – and there are indications that this is starting to happen – then higher inflation rates could be around for longer.
Loan growth started to take off early in the pandemic as the Fed stepped in with more than $2tn in lending and supported the provision of bank loans by temporarily relaxing regulatory requirements. The loan growth rate started to fall in March owing to the base effects, with the loan-to-deposit ratio of all US banks reaching 50-year lows.
With the pandemic now arguably in its final stages thanks to rising vaccination rates in many countries, a return to a pre-pandemic environment should lead to increasing loan growth again, which could serve to maintain the recent rises in inflation for longer. It is no surprise that the Fed’s Senior Loan Officer Survey in late March found that US banks’ willingness to lend was at its highest in years.
There are many reasons why banks will now seek to grow their loan books again. Firstly, many households used their additional stimulus-related income to pay back at least some of their existing loans. Secondly, when uncertainty was high during the spring of last year, banks took loan-loss provisions similar to the extent that occurred during the global financial crisis of 2008-09, naturally weighing on the propensity to make new loans.
This over-provisioning is now being reversed, with JP Morgan in the first quarter releasing about half of its loan-loss provisions taken in the previous year. Finally, the steepening yield curve increases the profitability of issuing loans, which are typically refinanced via short-term funding.
Another reason for the apparent retreat in bond yields appears to be the fear of renewed lockdowns because of the emergence of new Covid-19 variants. In the past few weeks, news about rising infection rates in countries where vaccination rates are high, such as Israel, the UK and the US, has led some investors to fear a relapse for many economies in the second half of the year.
The critical variable will be whether the number of hospitalisations remains muted. This would suggest that while vaccinations may not fully prevent new infections with aggressive variants of the virus, they will drastically reduce the probability of any severe disease progression. If the vaccines reduce the pressure on national health systems, Covid19-induced restrictions may continue to be relaxed.
We appear to be approaching a critical moment as the resolve of governments to resist pressure to lock down again is tested. The outcome will have a significant bearing over whether the rise in inflation will, in the end, be as “transitory” as the Fed expects.
Many households used their additional stimulus-related income to pay back at least some of their existing loans