Executive Summary

  • The three known COVID-19 variants are contributing to a third or fourth wave of infection, hospitalization, and death around the world. All three strains have arrived in the U.S. since January, and after a year of self-confinement, most Americans are looking forward to getting out and socializing. The battle now is the speed of vaccination vs. the speed of a new wave of infection from the spread of the new strains.  The base case is that 70% of the US population would have developed immunity by summer which should minimize the probability of further economy reopening setbacks.
  • We are expecting a 7% GDP this year in the U.S. if all goes well with vaccine adoption resulting in reopening sooner than later. With the seemingly endless ultra-accommodative monetary policies and a stream of fiscal transfers, personal savings is way up and household private net worth has exceeded pre-pandemic levels.  We are flushed with cash (nowhere to spend it last year) with palpable pent-up desire to return to our social and consumption normalcy.  These all are supportive of a booming economy for the near term.
  • The 10-year U.S. treasury bond yield has jumped more than 100bp (1%) from its 2020 March low. Most of the jump came the first quarter in response to a speedier economic recovery and brings the yield back to pre-pandemic level.  The economic conditions today are far more favorable, and we expect the rate to be over 2.5% this year.
  • The Federal Reserve is tasked with promoting and maintaining full employment and price stability to maintain favorable financial conditions. The new monetary framework of reactive rather than proactive policy action means that the Fed will wait until inflation is above the 2% target for sometime (likely 6 to 8 quarters) before reacting by normalizing rates.  The Fed expects that to be in 2023. If history is a guide, the Fed will likely taper (i.e. shrink its balance sheet and reduce and remove QE) before lift off from 0% interest rate.  The Fed intends to broadcast its policy path early to minimize market dislocation.
  • Inflation (CPI) for March is at 2.6%, and we expect this rate to go even higher at least for the next few months. This is partially due to the base effect where negative inflation rates of March, April and May in 2020 drop off and are excluded in future annualized calculations.  Moreover, the reflation of the economy as it normalizes will add inflationary pressure.  We agree with the Fed and the general consensus that these inflationary pressures are transitory in nature and this too is our base case, but it is possible that we move to a slightly higher inflation regime after the transitory period is over.
  • The challenge to the market is a hands-off Fed allowing nominal rates to rise which could also pull the real (inflation-adjusted) rate less negative. With a frothy market for risk assets, this continuation of rate rise would eventually impact stocks.  The pull and push between inflation, real bond yield and the anticipated Fed reaction will continue to add uncertainty and volatility to the bond and stock markets and, at times, with intensity.

Click here for the full commentary.