June Outlook
June 11, 2020  |  By Hank Cunningham

Fed Chair Jerome Powell delivered a sobering assessment of the current and projected economic landscape. The Fed will leave its Fed Funds Rate unchanged until 2022. While the Fed cannot directly control bond yields, it can exert considerable influence over them. Indeed, market observers believe the Fed may resort to some measure of yield curve control should yields rise more than the Fed would like.

There is a recovery underway, as witnessed by the stunning employment report and the strength in equity markets. Thanks to the Fed’s actions, liquidity has been restored to credit markets. Not only have yield spreads between corporate and government bonds narrowed, but there have been record numbers of new corporate bonds issued.

Government bond yields jumped twenty basis points after the June employment report but they retreated by the same amount after Chair Powell’s gloomy assessment of economic conditions. While not announcing any new measures, the Fed has made it clear that there is “no limit” to the tools it has at its disposal. Once again, the market has learned to “not fight the Fed.”

The consensus view is that, as the full effect of this unprecedented stimulus hits global economies, inflation will rear its head. It is not difficult to see sharp price increases ultimately in important items such as food, restaurants, air fares, hotels and wages. That moment is, however, far into the future as global economies struggle with the forces of deflation for the foreseeable future.

Thus far, the gigantic increase in the U.S. budget deficit has mostly been absorbed by the Fed’s balance sheet, which has ballooned by some $5 trillion dollars with no apparent ceiling. It is on its way to $10 trillion this year. With the Fed monetizing this deficit, one outcome has been a weak U.S. dollar. Our conclusion is that the yield curve will steepen further and that we have seen the lows in long-term government bond yields.

Along with a rebound in energy prices, this weakness in the U.S. dollar has led to a steady rise in the Canadian dollar.

As to bond yields, the Fed has anchored short-term yields close to zero. The yield curve has steepened, in recognition of not only the long-term implications of record issuance of Government bonds but also the ultimate increase in inflation.

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