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Fixed Income: 2021 reflation trade, where art thou?

Global Fixed Income

BNP Paribas Asset Management

In mid-June, Fed Chair Jay Powell pulled the rug from beneath the reflation trade by suggesting current inflation pressures were perhaps not transitory after all. Fixed income markets promptly reversed course with 10-year US Treasury yields last week trading as low as 1.25% after ending the first quarter at 1.70%.

Regime change in June? Or just a pause?

We recently saw the consensus view held by the market on US interest rates bowled over by the Federal Reserve. Whereas the market expected no or at the most one interest rate rise over the next two years, the Fed’s ‘dot plot’ indicated that policy rates could rise by as much as 50bp by 2023.

Prior to the Fed’s policy meeting in June, bond markets were clearly positioned for higher rates. The expectation in the market was that inflation would rise and the Fed was pursuing a new policy of driving inflation higher to reflate the US economy.

As a result, market participants were, in our view, overwhelmingly underweight interest-rate risk (duration) versus their benchmarks, in other words, the expectation was that bond prices would fall. Chair Powell’s comments triggered a repositioning on the basis that the Fed was, after all, not prepared to tolerate higher inflation and was ready to raise policy rates in response.

It is worth noting that all this affected positioning in not only US Treasury bonds, but also German Bunds. Here too, market volatility increased as participants reacted to the unexpected news.

While the Fed has appeared to let go of its – until recently – sanguine view on inflation and has shifted to an assessment that action is needed to contain price pressures in the economy, the apparent rationale behind June’s policy rate signal is clouded by a few provisos.

  1. The Fed’s ‘dot plot’ policy outlook indicated inflation would peak this year and be more muted in 2022 and 2023. That could have been a reason to hold off on a tightening signal.
  2. While macroeconomic data has been pointing to a strong recovery in the US from the pandemic-related shutdowns, there have been signs more recently that the peak in GDP growth is in fact in sight. It may even be behind us. Indeed, the recovery of the Chinese economy, which was first in and first out of the pandemic, has already plateaued. This too could have motivated the Fed to stick to the view that recovery-related inflation would dissipate.
  3. Finally, negotiations in Congress on the latest stimulus package – a set of large-scale infrastructure measures – are moving in the direction of a compromise reducing its overall size. That should limit its effect on the economy. More generally, there is a view that fiscal tightening is coming – an end will have to come to all the ‘doing whatever it takes’ – both in the US and Europe.
  4. Recent experience with the Delta variant of Covid-19 suggests there will be no rapid exit from the global pandemic, which may delay reopenings with negative economic consequences. There is also a marginal risk of new variants.

The Fed’s changed view – or was it just the tone – caused a highly unexpected, so-called bullish flattening of the US yield curve in which shorter-term yields rose to reflect the expected policy tightening in two years’ time, but 10-year rates held steady or eased.

Many investors had held positions anticipating a steepening, not flattening, of the US yield curve on the basis that higher inflation would drive interest rates higher. Now, however, there appear to be grounds for a very different narrative.

Our view today is that many participants have not yet adjusted to the change in narrative. There may well be further to go before we can think about a revival of the reflation trade. However, time is crucial in fixed income, who knows how events will change in the meantime? The reflation trade may well dust itself down and continue, but now it is very much on the ropes.

What happens next?

It is unclear what the Fed’s approach to monetary policy is now. Under its new framework, it had appeared that the central bank was focusing on average inflation and dealing with price pressures over a period of time. This had been seen to mean that a period of above-target inflation would follow a spell of below-target inflation to arrive at the average.

Now, however, there appears to be a view that more immediate action is needed, hence the expectation of two rate increases totalling 50bp by 2023. This shift back to the previous policy regime has dented central bank credibility and left markets with a greater need for clarity. This matters not just for Fed watchers, but also for those following the ECB, which has signalled it would react if there were large diversions from its newly firmed-up 2% inflation target.

Are there any implications for plans by the Fed to taper its trillion-dollar support for the US economy? The central bank has started discussions on reducing its (stocks of) asset purchases in light of the progress the economy has made on restoring employment and inflation, but appears to be leaving aside risks to growth such as fiscal tightening, in other words, any tax increases the Biden administration is considering to help pay for the stimulus packages.

For investors, we think markets now understand that the tapering of monetary support – unwinding the asset purchases that were to hold down rates as the economy sought to recover from the pandemic-induced – is a process whose effects last longer than previously thought. It is also important to differentiate between the stocks of assets held by central banks, which will remain stable, even when the flows change as central banks taper.

As a result, there is an inclination to hold on to overweight positions in sovereign debt by investors keen to benefit from the carry such assets provide, even as tapering gets underway. This may initially limit any move higher in interest rates.

The impact of tapering is likely to be felt first in other fixed-income sectors than G7 sovereign debt. We would be more concerned about the prospects for US high-yield bonds where default rates have been very low in the wake of support from the Federal Reserve than about US Treasuries.

What is the outlook?

We have had conflicting signals from policymakers. The situation with regard to inflationary risk and whether it requires higher interest rates varies across countries. There are clearly some emerging markets where the rise in inflation will not be temporary and policymakers will be raising rates.

Economists are debating different theories on just how recent central bank policy will influence long-term economic growth and inflation. We anticipate central banks may at times struggle to retain their credibility. There is huge discussion about whether the pandemic has fundamentally changed the outlook for wage inflation in labour markets. Our view is that it is just too early to give a definitive answer.

Expectations for US inflation in five years’ time have fallen after the Fed’s comments in June, but also on the view that growth in many countries is peaking or is close to peaking. We think the US Federal Reserve currently has a window of opportunity to talk about tapering. We will learn more at the next meeting of the FOMC on 27-28 July.

While it is clear that rates will rise eventually, it is now also clear that markets are prepared for that eventuality. If tapering is the first step to policy tightening, it now looks less likely that there will be a ‘tantrum’ when the process actually kicks off.

Equally, the ground has been prepared in the case that inflation is not as temporary as (some) central bankers had made it out to be. Today, we find it hard to be very optimistic about prospects for global growth. That clouds the picture for the inflation outlook too.


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