Markets appear to have bought into the US Federal Reserve’s view that the recent spike in inflation is “transitory” and the result of reopening economies, which will gradually fade in the coming quarters 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 a number of 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 being drawn down steadily to about $750 billion at the end of June, from a balance of above $1.8 trillion in July last year. 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 in the medium term, 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 won't 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 stay with us 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 due 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 spikes 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 a number of 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 during the pandemic. Secondly, when uncertainty was high during the spring of last year, banks took loan-loss provisions similar to the extent last seen 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, for example, in the first quarter releasing about half of its loan-loss provisions taken in the prior year. Finally, the steepening yield curve increases the profitability of issuing loans, which are typically refinanced via short-term funding – the classic term transformation of the banking sector.
Meanwhile, another reason for the apparent retreat in bond yields appears to be the fear of renewed lockdowns due to 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 due to renewed lockdowns and flare-ups in supply disruptions.
The critical variable will be whether the number of hospitalisations remains muted, which 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 stress to national health systems, Covid-19-induced restrictions may continue to be relaxed, thereby keeping economic activity underpinned.
As far as this debate is concerned, we appear to be approaching a critical moment as the resolve of governments to resist pressure to lock down again in the coming weeks gets tested – the outcome of which will have a significant bearing over whether the current spike in inflation will, in the end, be as “transitory” as the Fed expects.
Tim Fox is a prominent GCC economist and financial markets analyst, and an adviser to Switzerland-based St Gotthard Fund Management