This metric signifies that an financial increase is imminent – and probably inflation

One person is training at Planet Fitness when it reopens in Boston’s Dorchester on February 1, 2021 at a 25 percent capacity.

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While Washington argues over incentives, the bond market is already anticipating a lot of household spending and an economic recovery. In extreme cases, inflation can pose a risk.

The metric the bond market is observing is the yield curve for government bonds, or the difference between interest rates for different maturities, which has now reached its steepest level since May 2017.

A steeper curve is typically viewed as a positive sign for the economy, stock market, and corporate earnings, while a flattening curve is a warning of economic weakness.

The widely observed yield curve shows the difference between short-term and long-term interest rates.

In this case, considering the 2-year return of 0.11% and the 10-year return of 1.12%, the spread is 1.01 and increases as the 10-year return increases. The prices move against the price.

“It is driven by the fact that politics, fiscal and monetary policy, allow for stronger economic growth for longer without the Fed in the way, and that the business cycle basically extends further into the future,” he told Jim Caron , Head of Global Macro Strategies, Morgan Stanley Investment Management Global Fixed Income Team.

There are expectations for inflation to rise and that is being priced into the market, he said.

“It’s really about an economic upswing that enables politics to support this upswing,” said Caron. “That is the main reason why the curve is steeper.”

The curve is also getting steeper as pessimism about Covid-19 subsides and vaccines roll out, said Mark Cabana, head of U.S. short rate strategy at Bank of America.

“The acute focus on downside risk may be slowly fading and who knows exactly what it’s going to do in six months, but I think the market is realizing that some of the worst-case scenarios are unlikely to be as severe,” he said.

Bank of America recently raised its 10-year return forecast from 1.5% to 1.75% at the end of the year, according to Cabana.

“It’s because of the belief that there will be fiscal incentives,” he said. “That it will greatly support economic growth.”

“It will improve longer-term growth and inflation expectations, and over time the market will become less focused on downside risk and more focused on upside risk,” added Cabana.

Covid relief and extra support

The market is also focused on the $ 1.9 trillion Covid aid package proposed by the Biden government, which is expected to be approved in a reduced form. But more spending is also expected to follow, adding to a recently completed $ 900 billion Covid package.

“Is it a trillion or more than a trillion? It’s somewhere in this neighborhood, all in a year that we expect good economic growth, but we need good economic growth next year as well,” said Caron.

“The goal is to close the output gap so we can make up for last year’s loss and get back on trend,” he added. “This stimulus round – whenever it is passed – is not the last.”

The market is currently evaluating the potential economic impact of the relief, rather than the expected increase in debt from these spending, Cabana said.

Other signs of improvement

According to James Paulsen, Leuthold Group’s chief investment strategist, the steeper yield curve is in line with other data showing an improvement in the economy.

“I think it’s a pretty decent signal for economic recovery,” he said.

“Personally, I think we could see GDP growth of 6% to 8% this year,” added Paulsen. “Inflation is part of it.”

The average forecast by economists for growth in 2021 is 5% in the Moody’s Analytics / CNBC Rapid Update.

If inflation gets too high, it could result in negative earnings for stocks and hurt corporate profits by putting pressure on margins, Paulsen said.

On Wednesday, the 5-year break-even inflation rate, a measure of inflation expectations in the Treasury market, was 2.30, the highest level since April 2013. This means that market professionals will have an average inflation rate of 2.3 for the next five years % expect. The key figure compares the yield on 5-year government bonds with the TIPS grade of the same term.

“It’s a lot compared to interest rates,” said Peter Boockvar, chief investment officer for the Bleakley Advisory Group. “The question is whether the market cares. Obviously it hasn’t interested. I think it’s the biggest risk.”

The Fed has announced that it will keep interest rates low for a long time, continue to buy bonds and keep inflation in an average range that could rise above its 2% target without triggering a rate hike.

Cabana said the Fed would be positive about rising inflation expectations.

“It tells you this is the kind of rate hike the Fed wants to do. Higher expectations for growth and inflation,” he said. “When the Fed looks at this, they see it as a healthy slope.”

How is that different from last time?

Fixed income strategists say fiscal policy is helping to steep the curve this time around.

The last time the spread between 2 and 10 year yields was at this level was when Donald Trump was in the White House for just a few months and the market was still expecting tax cuts.

However, the 2-year ratio was 1.26% and the 10-year ratio was 2.27%, and the yield curve flattened from a steeper level.

“The economy finally recovered from the financial crisis,” said Michael Schumacher, director of interest rate strategy at Wells Fargo. “People were thinking about bullish economic policies. There were more signs of growth and people were talking about tightening the Fed.”

Morgan Stanley’s Caron said that the curve does not usually steepen as the longer terminal rates increase – that is, 10-year rates and beyond. When this is the case, a negative period often follows for the markets.

That’s because the Fed is usually willing to hike rates when long-end rates rise, which slows the economy down.

This time around, the Fed will stay on hold and the government will likely spend money to help an emerging economy grow even further, Caron said.

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