Analysis: Reflation rethink sends bond markets into a spin

The front facade of the New York Stock Exchange (NYSE) is seen in New York, U.S.

An economy powering back from the COVID-19 shock and resurgent inflation is yesterday’s story if the sharp rally in the world’s biggest bond markets in the last 24 hours is anything to go by.

Prices on U.S. 10-year Treasuries have shot up, pushing yields down 8 basis points on Tuesday in their second biggest daily drop of 2021. The rally accelerated on Wednesday, with yields falling to just below 1.3%, their lowest in over four months.

British gilt yields fell to a similar low while German Bund yields — which looked set to push above 0% in May — have dropped to -0.3% , .

Various explanations have been proffered: a squeeze on investors who had bet on yields rising, softer-than-expected economic data and concern about COVID variants.

Push past the noise and the real message from sovereign bond markets — watched closely by policymakers and investors alike as a key indicator of economic trends — is clear: economic growth, while firmer, looks to have peaked, and any pick-up in inflation will likely prove transitory.

“Markets have gone from thinking that growth is strong and inflation could be strong to saying growth has peaked and inflation is transient,” said Guy Miller, chief market strategist at Zurich Insurance Group.

The turnaround in bond markets may not fit with the message from the U.S. Federal Reserve, which has just shifted to a hawkish bias and brought forward its trajectory for rate hikes.

But even with that shift, the Fed does not expect to start raising rates until 2023 and, like other major central banks, has stressed it will look past any short-term rise in price pressures.

Fed officials last month felt substantial further progress on the U.S. economic recovery “was generally seen as not having yet been met”.

“You have to change your view given the facts that you are faced with – economic growth is not solid, inflation is not about to surge,” said Pictet Wealth Management strategist Frederik Ducrozet.

The rush back into bonds comes as data reinforces the view that economic growth may have peaked.

Data on Tuesday showed U.S. service sector activity grew at a moderate pace in June, while a closely-watched gauge of German investor sentiment fell more than expected in July.

The bond rally would have inflicted losses on the multitude of traders with “short” Treasury positions – essentially a bet that yields would rise in line with a recovering economy – forcing many to liquidate those trades, pushing yields lower still.

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