Post-COVID World Slowly Begins to Come into Focus
The much-talked-about reflation trade has gained additional momentum on the heels of the Democratic victory in the Georgia Senate run-off. Democrats successfully flipped both seats, thereby gaining control thanks to the vice president’s deciding vote, which grants the Biden administration more flexibility in pursuing its policy agenda. This “blue wave light” is expected to bring about greater fiscal spending to address infrastructure, climate change, healthcare, and additional COVID relief.
While positive for economic growth in the short term, this deluge of new debt has prompted upward pressure on yields as markets adjust their inflation expectation accordingly. This is being reflected in the 2s/10s spread, the difference between the yield of the 10 Year U.S. Treasury Bond and the 2 Year U.S. Treasury Note, which has reached its highest level since 2017. Additionally, the 10 Year breakeven inflation rate, the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity, has reached levels we haven’t seen since the end of 2018.
2YR/10YR Treasury Bond Yield Spread (Black), U.S. 10 Year Breakeven (Orange) - Source: Bloomberg
This repositioning around a Democratic-controlled Senate, and an anticipated widening of deficits can also be seen in other asset classes. The commodities complex moved higher, the dollar sunk to fresh multi-year lows, and cryptocurrencies continued their parabolic ascent. Within equities there has been a meaningful rotation into energy, materials, financials, and select industrials.
Bloomberg Dollar Spot Index (Black), Bitcoin (Orange), Gold (Blue), Bloomberg Commodity Index (Purple) - Source: Bloomberg
Wednesday saw the release of the Fed minutes from December. The FOMC remains unphased by inflation, with most committee members still seeing downside risks. The minutes stress that the new guidance is “qualitative,” meaning that there aren’t numerical targets on their policy goals granting them significant leeway on any kind of response. As far as tapering, there was some discussion on the process, and the 2013-2014 precedent was cited as a useful model however the timing of when any tapering would begin was not discussed. They will tread carefully in this regard in hopes of avoiding market reactions similar to the 2013 taper tantrum or the selloff in late 2018. They still see the virus as a significant risk, and with new mutations being discovered and logistical difficulties in administering the vaccines, this seems warranted. There are nearly 10 million workers still displaced and the latest data on household incomes showed a sharp deceleration as various support programs recently expired. So, while trillions of dollars have been thrown at keeping the economy afloat, these problems will persist unless they can effectively get assistance into the hands of individuals that need it the most.
U.S. Labor Force Participation Rate (Black), U.S. Personal Saving as a % of Disposable Income (Orange) - Source: Bloomberg
Regardless of these risks, stocks continue to make new highs fueled by easy financial conditions, a vaccine rollout, massive fiscal stimulus, and dollar weakness. By the end of the second quarter the focus should begin to shift back to valuations and earnings as the pandemic hopefully subsides. Companies will need to deliver in order to justify current investor expectations. If we can continue to see labor market improvement in a reopening economy, this could provide the right environment to help propel equities further as pent-up demand is finally unleashed.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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