Week in Review: July 12, 2021

Markets generally ended the week lower with the exception of the S&P 500 which closed at a new record high. However, the modest increase belied some intraweek volatility. On Thursday the 10-Year Treasury yield briefly fell to 1.25% garnering the attention of equity markets. Entering 2021, it was widely expected that interest rates would rise as economic activity rebounded. That held true in 1Q21 as the 10-Year Treasury yield increased from 0.93% to 1.74%. However, since then, interest rates have defied expectations by steadily falling, even as economic data has remained robust, begging the question “Why?”

The most prevalent explanation is that bond investors expect economic activity to return to its modest pre-pandemic baseline after the current surge dissipates. However, until recently equity markets seemed more concerned about inflation than growth. That sentiment seemed to shift during the week and accelerated on Thursday, when the 10-Year briefly hit 1.25%, down 0.19% from the start of the week. The immediate decline was attributed to Japan’s decision to ban spectators from the Olympics after declaring a state of emergency amid rising coronavirus cases. More broadly, the 10-Year reaching the psychological level of 1.25% seemed to crystalize growing concerns about longer-term economic growth, with some economists speculating that activity has already peaked.

In that light, actions taken by the People’s Bank of China (PBOC) and European Central Bank (ECB) made more sense than they initially appeared, and would suggest that policy makers are also anticipating slower economic growth. In China, the PBOC cut the reserve requirement ratio (RRR) for all banks by 0.5%. The RRR reduction will effectively free up $154B for banks to lend in support of economic growth. In Europe, the ECB revised its inflation target to 2% instead of the prior “below, but close to, 2%.” And similar to the Fed’s new approach, the ECB acknowledges that inflation may run above target at times. That would seem to suggest that policy will remain the same, or even become more accommodative, in order to achieve the new goal.