Inflation is generally bad news for bond prices, eroding the value of fixed payments offered by debt and increasing the likelihood that central banks will respond with interest rate hikes.
But the last few months have turned that relationship upside down, at least for longer-term debt. U.S. Treasuries prices posted big gains – with other bonds from around the world in their wake – pulling the 10-year yield to its lowest level in more than three months this week, to just under 1 , 3%, against 1.75% at the end. Of March.
“There are a lot of puzzles going on,” said Mike Riddell, portfolio manager at Allianz Global Investors. “At first glance, this movement seems quite counter-intuitive. “
Investors have looked to recent signals from the Federal Reserve regarding changes in its sensitivity to high inflation as an explanation for the seemingly unstoppable rally in government bonds. Wall Street was put on alert in June following the publication of the Fed’s dot plot of policy makers’ interest rate projections. This suggested the possibility of a much faster tightening of monetary policy than initially indicated when the Fed adopted an average inflation target of 2% last year that would include periods of overshoot.
Jay Powell, the chairman of the Fed, discouraged market participants from over-reading these individual forecasts and urged patience with the eventual removal of political support. But he also acknowledged the risk that the Fed would have to respond to higher-than-expected price pressures.
“We are experiencing a sharp rise in inflation – larger than expected and certainly larger than I expected – and we are trying to figure out if this is something that will pass quickly enough or if, in fact, we must act, ”he said. during a congressional hearing Thursday.
“Either way, we’re not going to enter a period of high inflation for a long time, because of course we have the tools to address it. But we don’t want to use them in a way that is unnecessary or that interrupts the rebound in the economy. “
Coupled with the recent admission that Fed officials are starting talks about reducing the $ 120 billion monthly purchases of agency treasury bills and mortgage-backed securities, this shift in stance has convinced many. investors that the Fed will be less tolerant than before in the face of soaring inflation expectations. thought.
“The Fed has effectively ruled out some of the more extreme scenarios the market was worried about,” said James Athey, bond fund manager at Abrdn. “The more rate hike expectations are integrated, the less inflation should get out of control. “
The increase in coronavirus cases linked to the more transmissible Delta variant has also rekindled fears that the economic boom linked to the reopening of large swathes of the global economy may fall short of the extremely optimistic forecasts put forward by economists more early in the year. But with stock markets buoyant around record highs, investors are reluctant to conclude that the bond market – a magnet in times of stress – signals a bleak new outlook for the global economy.
Instead, many continue to point fingers at investor positioning – a familiar culprit of Treasury market gyrations since the June Fed meeting. In the first quarter of the year, as investors braced for the US economy to reopen and inflation to return, they bet heavily on higher long-term yields, while also betting that the Fed would keep short-term yields locked in. Many of the subsequent moves can be explained by investors abandoning these so-called steepening trades – often reluctantly – as markets have moved against them and losses have risen.
“None of the great stories to explain this rally are working for all of the past few months,” said Riddell. “That’s why I think it makes sense to talk about positioning.
Despite a series of setbacks, some are sticking to the steepening of trade, arguing that the apparent contradiction between soaring inflation and falling bond yields is unlikely to last. At some point, the Fed will be forced to reconsider its view that the current inflation surge will prove to be mostly transient, rocking the bond market as investors brace for a quicker cut in stimulus, according to Mark Dowding, chief investment officer. director of BlueBay Asset Management.
“Bonds should be naturally allergic in their reaction to inflation,” Dowding said. “We suspect that we may go back to the current period in the markets a little later in the year and consider some of the trends that we are seeing as relatively strange. “