The new nominal theme – which flags a more muted response in nominal government bond yields to rising inflation than in the past – has played out since last year. Inflation-adjusted yields, or real yields, have fallen further into negative territory as a result. Additional fiscal spending could turbocharge a vaccine-led economic restart later this year – one that we believe may exceed market expectations.
Activity in many services sectors is already compressed with less room to decline further. Businesses have also adapted to an environment of social distancing, allowing operations to continue. Consensus expectations of the size of the shock have been revised down materially, particularly for the euro area. Vaccine rollouts are likely to stoke a sharper-than-anticipated rebound.
A Different Shock
We see pent-up demand in contact-intense services rebounding sharply once restrictions lift in the U.S. and euro area – as seen in China, and supported by the accumulation in personal savings.
U.S. consumers have built up a savings buffer equivalent to more than 12% of annual consumer spending over the past year. Not only is the policy response this time far more overwhelming, but a large part of economic activity will restart on its own once the pandemic is under control, in our view. This is a key difference with the Global Financial Crisis (GFC). The objective of the current policy response has been different: it is not to stimulate growth, but to provide a bridge to the post-Covid world.
Policymakers, academics, taxpayers and markets have been surprisingly relaxed about the large increase in debt – also a stark contrast to the aftermath of the GFC, when the focus shifted to austerity.
Record-low debt servicing costs help explain more sanguine attitudes to high public debt levels. Public debt in the U.S. is set to reach a record 135% of GDP, according to IMF forecasts. This is twice as high as in the 1990s, but financing costs are only half what they were then. For now we see the new nominal theme at play: a more muted response in nominal government bond yields to rising inflation.
Stable and Negative Real Yields Support Our Pro-Risk Stance
Rising U.S. 10-year yields reflect the repricing higher of inflation expectations. We believe central banks have strong incentives to lean against any rapid rise in nominal yields. Yet we still see gradual increases in yields as markets price in a rapid economic restart supported by fiscal stimulus. We underweight U.S. Treasuries as a result.
The Bottom Line
We broaden our tactical pro-risk stance in light of major developments since the publication of our 2021 outlook in December: the vaccine rollout and up to $2.8 trillion of additional U.S. fiscal spending this year. Inflation expectations have risen sharply while real rates are steady in negative territory. We prefer equity over credit and turn underweight government bonds – in line with our strategic views.