J.P. Morgan's Kelly: Why the Bond Market Is Ignoring Inflation

Recent reports have shown consistent upside surprises on measures of wages and home and consumer prices, culminating in the June 10 U.S. Bureau of Labor Statistics consumer price index report for May, which showed a 5% year-over-year gain in overall CPI, and a 3.8% increase when food and energy are excluded. 

Despite this, however, long-term interest rates have edged down, with the 10-year Treasury yield falling to 1.45% on June 10, its lowest level since the start of March.

There are two broad possibilities why this is happening, David Kelly, chief global strategist at J.P. Morgan Asset Management, said in a weekly note.

Kelly said investors may perceive some weakening in the pace of recovery and agree with Federal Reserve officials who maintain that any near-term price pressures are merely part of a transitory interlude before a return to stable or falling inflation.

A second possibility, he said, is that technical forces in the bond market are suppressing long-term interest rates, at least for now.

Kelly said it behooves investors to pay attention to this debate because if the Fed is wrong and higher inflation becomes imbedded in the economic landscape, technical forces should eventually subside. This would allow long rates to move higher and restart the rotation from growth to value, which has characterized much of this year so far.

According to Kelly, those who argue that inflation pressures are actually easing could point to two consecutive jobs reports that have disappointed both with respect to payroll gains and declines in unemployment. 

He noted, however, that healing in the job market most likely is just being delayed by a few months because of lingering effects of the pandemic and relatively generous unemployment benefits. In fact, the economy continues its rapid reopening, and enhanced unemployment benefits will expire in half the states by early July and the other half by early September.

This combined with evidence of robust labor demand — confirmed by the June 8 Job Openings and Labor Turnover report — should lead to a rapid increase in employment and decline in unemployment over the next six months, Kelly said. In the meantime, wage growth has clearly accelerated, and this should continue to add to inflation pressures into 2022.

Moreover, he said, further fiscal stimulus looks likely before year-end, composite PMI data show global economic activity accelerating at its fastest pace in 15 years and West Texas Intermediate Crude oil prices closed out last week above $70 per barrel for the first time since October 2018. 

“Mapping all of this into our economic models suggests inflation in the fourth quarter of between 3.5% and 4% year over year as measured by the personal consumption deflator, which is the Fed’s favorite inflation gauge,” Kelly said.

Technical Forces 

But something other than expectations about the economy or inflation could be significantly suppressing yields, Kelly said.

One issue continues to be low foreign yields. To the extent that global investors see these bonds as substitutes for U.S. Treasurys, their consistently low yields are likely acting as an anchor on U.S. yields, according to Kelly.

A second issue is that many institutional and individual investors are rebalancing their portfolios, buying bonds and selling stocks. More than $350 billion has flowed into long-term bond funds and ETFs so far this year compared with just $152 billion on the equity side, Kelly noted, citing Investment Company Institute data.

The biggest factor, however, may be a temporary lull in the supply of Treasurys, he said. 

The Treasury drawdown of its account at the Fed is nearing its end. Kelly expects that this week’s Fed communications will hint at a tapering of Fed bond purchases by the end of this year or early next year. 

If this happens, he said, long-term interest rates will likely resume their ascent, which should benefit fixed income investors who are short duration and equity investors who are tilted toward value over growth.