Thursday, June 1, 2023

‘Strange’ bond reaction to US inflation data puzzles investors


A relentless rally in US Treasuries has accompanied the biggest burst of inflation in more than a decade, snapping typically reliable patterns and leaving investors scrambling for an explanation for what is going on in the world’s largest bond market.

Inflation is typically bad news for bond prices, eroding the value of the fixed payments the debt offers and making it more likely that central banks will respond with interest rate rises.

But recent months have turned that relationship on its head, at least for longer-dated debt. US Treasuries prices have run up big gains — with other bonds around the world following in their wake — pulling the 10-year yield to its lowest in more than three months this week just under 1.3 per cent, down from 1.75 per cent at the end of March.

“There’s a lot of head scratching going on,” said Mike Riddell, a portfolio manager at Allianz Global Investors. “On the face of it this move looks pretty counterintuitive.”

Investors have homed in on recent signalling from the Federal Reserve about its evolving sensitivity to elevated inflation as one explanation for the seemingly unstoppable rally in government bonds. Wall Street was put on high alert in June following the release of the Fed’s “dot plot” of policymakers’ interest rate projections. That suggested the possibility of a much swifter tightening of monetary policy than initially indicated when the Fed last year embraced an average 2 per cent inflation target that would include periods of overshooting. 

Jay Powell, the Fed chair, has discouraged market participants from reading too much into these individual forecasts and urged patience about the eventual removal of policy support. But he has also acknowledged the risk that the Fed may need to respond to higher-than-anticipated price pressures. 

Line chart of 10-year US government bond yield (%) showing Treasury yields have tumbled

“We are experiencing a big uptick in inflation — bigger than many expected and bigger certainly than I expected — and we are trying to understand whether it is something that will pass through fairly quickly or whether if in fact we need to act,” he said at a congressional hearing on Thursday.

“One way or the other, we are not going to be going into a period of high inflation for a long period of time, because of course we have tools to address that. But we don’t want to use them in a way that is unnecessary or that interrupts the rebound of the economy.”

Taken together with the recent admission that Fed officials are beginning discussions on the scaling back $120bn monthly purchases of Treasuries and agency mortgage-backed securities, this shift in stance has convinced many investors that the Fed will be less tolerant of runaway inflation expectations than previously thought.

“The Fed has effectively removed some of the more extreme scenarios the market was worrying about,” said James Athey, a bond fund manager at Abrdn. “The more that rate hike expectations are baked in, the less inflation is expected to run out of control.”

Rising coronavirus cases linked to the more transmissible Delta variant have also renewed fears that the economic boom tied to the reopening of large swaths of the global economy will fall short of the extremely optimistic forecasts put forward by economists earlier in the year. But with equity markets buoyant around record highs, investors are reluctant to conclude that the bond market — a magnet in times of stress — is signalling a newly grim outlook for the global economy.

Instead, many continue to point to investor positioning — a familiar culprit for the Treasury market’s gyrations since June’s Fed meeting. In the first quarter of the year as investors prepared for the reopening of the US economy and the return of inflation, they bet heavily on higher long-term yields, while also wagering that the Fed would keep short-term yields pinned down. Many of the subsequent moves can be explained by investors ditching those so-called steepener trades — often reluctantly — as markets moved against them and losses mounted.

“None of the grand narratives to explain this rally works for the whole of the last few months,” said Riddell. “That’s why I think it makes sense to talk about positioning.”

Despite a series of setbacks, some are sticking with the steepener trade, arguing that the apparent contradiction between soaring inflation and plunging bond yields is unlikely to last. At some point, the Fed will be forced to back away from its view that the current bout of inflation will prove mostly transitory, jolting the bond market as investors prepare for a more rapid wind-down of stimulus, according to Mark Dowding, chief investment officer of BlueBay Asset Management.

“Bonds should be naturally allergic in their reaction to inflation,” Dowding said. “We suspect that we may look back at the current period in markets some time later in the year and view some of the trends we are witnessing as relatively strange.”

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