Bond Bulls Call Time on Reflation Trade as Global Risks Emerge

(Bloomberg) -- After a months-long tussle with reflation trades, bond bulls are finally regaining the upper hand.

The rate on 10-year Treasuries fell below 1.30% on Wednesday to the lowest in more than four months, leading declines in yields as the delta strain of Covid-19 hobbled hopes for an imminent end to the crisis and a normalization of central-bank policy. In Europe and the U.K., 30-year yields led a pullback across the curve, while China’s bond futures posted their best rally this year.

Traders have pushed back their expectations for a tapering of asset-purchase programs, with some in China even calling for interest-rate cuts. For HSBC Holdings Plc’s long-term bond bull Steven Major, it’s reason to think yields had already hit their peak for the year even as the economy bounces back from the coronavirus crisis. Bond markets are pricing reflation in, he said.

“The market is increasingly sensing that yields may have already peaked this year,” Major wrote in a client note. “There is no change to our long-term bullish view and forecasts of 1.0% for 10-year yields for year-end 2021 and 2022.”

Bond investors are culling trades based on an inflationary overshoot amid fears of a so-called short-squeeze that would force them to close positions targeting a slide in Treasuries. Aberdeen Standard Investments now says yields could drop below 1.2%, while AllianceBernstein LP sees rates potentially sinking as low as 1.12% -- a far cry from predictions, just a few months ago, that yields could break above 2%.

“The reflation story has just taken a massive whack,” said Liam O’Donnell, a money manager at Aberdeen. “If you don’t think that inflation is running out of control, and you don’t think interest rates are going anywhere for two years, then there’s nothing to fear in buying bonds at these levels, or lower.”

Several factors are in play. Most crucially, the argument for transitory inflationary pressures seems to be winning out -- something that’s not necessarily contradicted by the Fed’s lack of tolerance for a spike in inflation and higher rate-hike expectations after last month’s meeting. Haven assets are also getting a boost as the delta variant surges around the world.

Acting Sooner?

“Growth concerns around the delta variant are the key driver,” said John Taylor, a money manager at AllianceBernstein. Some investors are interpreting the Fed’s dot-plot shift as meaning it “will act sooner and therefore not raise rates as much as would be needed if they had allowed inflation to run hot for a lot longer,” he said.

Further support comes from the less-liquid summer months, when investors tend to buffer their portfolios with haven assets to protect against unexpected market jolts. On top of that, the supply-demand dynamic in bonds is unusually favorable -- the only securities on the Treasury department’s auction schedule this week are bills.

Still, Richard Hodges, a money manager at Nomura Asset Management sees the recent rally as an opportune time to initiate fresh short positions given that many other assets like oil are still flashing inflationary warning signs. While Major is still bullish, he said investors should turn tactically “neutral.”

“It’s madness to think we are in a bond bull market,” Nomura’s Hodges said. “Everything else is higher -- equities, inflation, oil prices, food, wages. And yields are going lower as we are sold the inflation roll-over transition.”

Traders, for now, have a close eye on the economic data and the steady drip of clues on the outlook from central banks. Tuesday’s Treasury rally was initially spurred by the ISM Services Index for June falling more than expected from May’s record high. Focus will now turn to the minutes of the Fed’s June meeting, before the highlight of the central banking year: Jackson Hole in August.

“The next few weeks, ahead of the Jackson Hole, could see a continuation of the squeeze as it’s clear from yesterday’s price action that a short base exists in the market,” said Aberdeen’s O’Donnell, who has added bond duration across portfolios. “The only thing that’s really ‘reflating’ is asset prices.”

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