By Yoruk Bahceli
(Reuters) – If bond markets are taken at their word, the post-global pandemic will be defined by stagflation, a toxic scenario that seems at odds with the rebound indicated by robust economic data and record stocks.
The decline in stagflation – high inflation coupled with low growth – is confusing and, according to many investors, untrustworthy. Instead, they say, it reflects how central banks’ hold on bond markets has distorted the signaling power of the markets.
Bond yields, both nominal and “real”, which exclude expected inflation, plunged in the United States and the euro zone. Their message: weak growth, requiring years of ultra-accommodative monetary policy.
Yet, while real 10-year yields on U.S. Inflation-Protected Securities (TIPS) have halved since late March to a record low below -1.20%, a measure of future inflation, known as the breakeven rate, is not far from that level. the highest of the year.
The 10-year US breakeven point, the level of inflation where nominal bond and TIPS yields would equal, is now 2.35%.
“It almost implies that the markets are incorporating some form of stagflation,” said Craig Inches, head of rates and treasury at Royal London Asset Management (RLAM).
He said the markets appeared to expect “inflation rates to remain high and nominal yields to continue to fall.”
(GRAPHIC: breakeven inflation vs real return – https://fingfx.thomsonreuters.com/gfx/mkt/byprjodoepe/real%20yield%20vs%20breakeven%20aug%204.png)
Indeed, with surprising inflation data on the rise, the risk is that inflation will be less transitory than central banks think. American consumers also see inflation at 2.8% in five years, according to the latest monthly survey from the University of Michigan.
This is the yield message that contradicts robust growth expectations, recently revised upwards by the IMF.
“The only way to get a summary (of stagflation) is to believe the vaccines don’t work,” Inches said.
GROWTH SLOWS DOWN, DOES NOT REVERSE
Yet there are several reasons why investors may lose their exuberance in the face of growth.
First, new variants of COVID-19, which a Deutsche Bank investigation has found to be the number one concern in financial markets.
Second, slowing economic dynamics, as surprises from US data turned negative, according to indices compiled by Citi.
Yet even with all of this, Annalisa Piazza, Fixed Income Research Analyst at MFS Investment Management, is skeptical of how the bond markets appear to read the data.
“We are clearly not heading for a recession,” she said. While acknowledging that sentiment indicators are likely to have peaked and growth will moderate, the data “is consistent globally with a very strong growth rate,” she said.
Markets even lowered longer-term rate hike expectations, apparently fearing premature Fed policy tightening that would stifle the recovery.
Interest rate swaps now imply that the Fed’s key rate in five years – an approximation of the “terminal” interest rate – is 1.14%, notes ING Bank. In March, it was expected to rise by around 70 basis points.
That’s less than half of the 2.5% the Fed rate setters expect in the longer term. Indeed, the market suggests that growth will be lower than the Fed forecasts.
RLAM’s Inches said, however, that in a genuine fear of growth, yields and breakevens likely wouldn’t send mixed signals.
Instead, a bond rally would be accompanied by a collapse in breakeven rates, stocks and corporate bonds, as was the case during the COVID crisis of 2020, investors said.
(CHART: implied federal funds rate of just 1.1% in 5 years – https://fingfx.thomsonreuters.com/gfx/mkt/gdpzyrerdvw/UB5jE-implied-long-term-fed-rate-falls-sharply- from-march. png)
The danger is to read too much what the tightly controlled central bank markets say.
In the United States, the three-month moving average of what remains of the net treasury issues that investors can buy after the Fed buys, has fallen steadily this year and turned negative in July, according to Reuters based calculations. on data from the Fed and the SIFMA industry group. .
(GRAPHIC: More buys than sales? More buys than sales? – https://graphics.reuters.com/US-TREASURIES/FED/nmopaxoljva/chart.png)
Another problem is the dwindling liquidity in the $ 1.6 trillion TIPS market. The Fed holds more than 20%, down from less than 10% in early 2020, according to data from the Fed and SIFMA.
The record entry into the TIPS market by investors using inflation hedging has further exacerbated the pressure.
This left TIPS investors paying a premium for owning an asset less liquid than nominal Treasuries, said Patrick Krizan, senior economist at Allianz.
Krizan calculates that after adjusting for liquidity, the return on TIPS would have been -0.52% last week, well above a record low.
Since real yields directly feed into breakevens, an artificially low reading implies that breakevens overestimate inflation expectations.
(GRAPHIC: Liquidity premium depresses US real yield – https://fingfx.thomsonreuters.com/gfx/mkt/akpezgrgnvr/Cev73-liquidity-premium-depresses-us-real-yield.png)
“It’s far too aggressive, the drop in rates,” said Antoine Bouvet, senior rate strategist at ING. “Fixed income markets, they not only reflect economic developments but also supply-demand imbalances.”
That’s why, citing the coming economic recovery, many investors still expect 10-year Treasury yields to hit nearly 2% by the end of the year. Even Fed boss Jerome Powell admitted it was difficult to decode what the bond markets are saying.
Technical factors are “where you put things that you can’t quite explain,” Powell said recently.
(Reporting by Yoruk Bahceli; additional reporting by Ritvik Carvalho; editing by Sujata Rao and Susan Fenton)