• High economic optimism and more fiscal stimulus contributed to further curve steepening in the Treasury market in March
  • Economist estimates for 2021 growth and consumption are well above long-run trends, and recent measures of restaurant activity and air travel suggest the most negatively impacted sectors of the pandemic are beginning to thaw
  • Fed leaders continued to push back on inflation worries throughout March, and current market pricing for forward inflation is likely palatable for the Fed and its current objectives

Economic optimism remains high in U.S. financial markets, buoyed by improving Covid trends and solid economic data.  The passage of the $1.9 trillion American Rescue Plan (ARP) added more fuel to the recovery, particularly in the near term, and the Fed seems committed to keeping a heavy foot on the accelerator for the foreseeable future.  As such, there is a mainstream debate over inflation risks for the first time in many years. One could argue that the market is currently priced for an obstacle-free path of robust economic recovery, and another wave of Covid cases could potentially lead to another round of restrictions in parts of the U.S., something Europe has been dealing with again in recent weeks. That said, the broad economic outlook remains very positive looking forward, which fueled further steepening of the Treasury curve in March.

Robust Economic Growth Expected

While several economic measures softened relative to expectations in February, the general assumption was that unusually severe winter weather was the primary culprit for the downside surprises. With more normal March weather and another fiscal injection from the ARP, consumption appeared to resume to a well above average pace using credit card data as a guide. This optimism is evident in economist forecasts for 2021 real GDP growth. Using the Bloomberg weighted average economist forecast (more recent forecasts receive higher weighting), expectations for quarter-over-quarter growth (annualized) through Q3 are 4%, 9.6%, and 7.3%, compared to an average rate of 2.8% over the prior 50 years.

The combination of improved Covid trends and vaccine distribution, new fiscal aid, and strong recent economic data has helped change the narrative in the bond market, sending long-end Treasury yields and inflation expectations higher. On the data front, the Weekly Economic Index (WEI) published by the New York Fed turned sharply higher in March, as illustrated in Exhibit 1. The WEI is comprised of ten different economic metrics, and the data is compiled and scaled to a four-quarter GDP rate. In other words, if the current weekly reading were to persist for an entire quarter, the authors expect, on average, for GDP to rise or fall by that same amount over the same quarter relative to the year prior. The April 1 reading surged an all-time high of 7.25% (records began 1/5/2008).

The U.S. appears to be pulling away from Europe from an economic recovery perspective, the latter of which is struggling with elevated Covid rates and greater restrictions across the region. Exhibit 2 tracks dining activity in the U.S., U.K., and Germany relative to 2019 levels, and while not “back to normal,” the number of seated diners in the U.S. is closely approaching pre-Covid levels. Similar improvement can be seen in the air travel as well. According to Transportation Security Administration (TSA) data, the 7-day average of passengers screened at U.S. airports is up to 60% on a year-over-year comparison to 2019, a 15 percentage point increase year to date. 

As a nice cap to the first quarter, the March jobs report was robust. Nonfarm payrolls added 916,000 jobs over the month, more than 250,000 above expectations, and the prior two months were revised higher by 156,000 jobs . The unemployment rate declined 20 basis points (bps) to 6% and coincided with an increase in the labor force participation rate. In other words, the decline in the unemployment rate was attributable to a sharper increase in employment (+609,000) relative to the increase in the official labor pool (+347,000). Average hourly earnings declined 0.1% month-over-month, but the average work week surged to 34.9 hours from 34.6 hours the prior month. Put together, it implies a larger percentage of job gains in March coming from lower wage earners. Aggregate wages are now back to pre-Covid levels, despite nonfarm payrolls still down more than 8 million jobs from what was lost last March/April. Given the relationship between wages and inflation, it further fuels the inflation argument in some economic circles.

Fed Holding the Line

Fed leaders had multiple opportunities in March to alter its narrative related to the current recovery and future monetary policy. Fed Chair Powell continues to push back on any assertions that inflation is a concern for policymakers at this point. He and his colleagues do expect inflation to pick up in the coming months as the economy reopens (and the base effect for year-over-year comparisons), but they still contend that any above-target inflation in the near term will be transitory. Exhibit 3 provides a view of current market inflation expectations as measured by breakeven yields in the Treasury Inflation Protected Securities (TIPS) market. Both 5-year and 10-year breakeven yields have continued to rise, with 5-year breakevens now at the highest level since early 2006. The 5yr5yr forward figure measures the 5-year breakeven rate 5 years from now implied by the current 5-year and 10-year metrics. In mid-March, the 5yr5yr forward rate was equal to the Fed’s long-run target of 2%.

The Fed announced a policy framework change last September that involves average inflation targeting, which would allow for above-target inflation for “some time” to offset below-target inflation during the prior period. In other words, the Fed seems content to allow inflation to “run hot,” to an extent, in the near term to ensure a return to full employment and long-term inflation expectations anchored closer to the 2% long-run target. In that context, one could argue that his picture of inflation expectations is not unsettling to the Fed in that it shows the 5yr5yr forward rate settling closer to the 2% target. That said, another significant shift higher in inflation expectations would present a greater challenge to Fed leaders and their ability to “sell” the transitory argument.

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