Why a bond rally could drive the 10-year Treasury yield lower still, even as inflation expectations become unmoored

The once-popular reflation trade is giving way to an entirely different kind of trade as investors begin to factor in both slower-than-expected U.S. growth, along with the prospects of a prolonged period of higher inflation readings.

Gang Hu of the New York-based hedge fund WinShore Capital Partners calls it “the tapering trade,” which involves selling stocks and commodities, while buying long-end Treasurys. It’s a dynamic that’s already under way and set to drive the 10-year rate
even lower from here, he said, after the yield dropped on Monday below 1.20% to its lowest level since February.

Ordinarily, higher inflation expectations would translate into higher yields, as investors prepare for the Federal Reserve to lift rates and start factoring in brighter growth prospects. Instead, such expectations are only underscoring concerns that when the Fed first reacts by tapering bond purchases, it will severely hurt risk assets, leaving bonds as perhaps the best safe haven.

The “tapering trade” is in contrast to earlier fears of a so-called “taper tantrum,” in which yields were expected to soar at the first sign of a Fed ready to scale back on its bond purchases.

Earlier: Why the bond market might not suffer another taper tantrum when the Fed signals it’s ready to move

On Monday, Treasurys rallied amid a stock-market rout as investors adjusted to the likely economic impact from the intensifying spread of the delta variant of the coronavirus that causes COVID-19. The Dow Jones Industrial Average
remained down more than 870 points, or 2.5%, in afternoon trade, while the S&P 500
slumped 2%.

While markets are still determining whether year-over-year U.S. consumer-price index increase of 5% and higher will prove to be transitory, Hu said inflation expectations already seem to be coming unanchored, judging by anecdotal reports about the willingness of many businesses to pass on higher costs.

At the same time, the Federal Reserve isn’t prepared to start hiking rates, in order to squelch higher prices, until it first signals a start date for tapering its monthly purchases of $80 billion in Treasurys and $40 billion in mortgage-backed securities. Meanwhile, the purchases have left markets flush with liquidity and investors still heading into bonds.

“By and large, inflation is a linear story and that’s fine until you hit a roadblock and inflation expectations get unanchored, meaning there’s a wage-price spiral in which the demand for higher wages gets passed on to higher prices,” said Hu, a managing partner and TIPS trader, in a phone interview.

“The unanchoring of inflation expectations is happening now, putting the Fed in a tough position. The Fed’s job is to cut off that spiral before inflation goes berserk. But it hasn’t done that yet, and the whole thing could unravel very quickly, with the risk that the central bank will need to turn hawkish.,” Hu said.

The Fed, which meets on July 27-28 in Washington, will discuss the tapering of its bond purchases in coming meetings, and still expects inflation to eventually moderate, Chairman Jerome Powell testified last week. Theoretically, it could be several months after the tapering process is well under way before policy makers are able to actually hike rates to address higher inflation, with many penciling in the first move to occur in 2023.

For much of this year, investors had been embarking on reflation trades, which tend to benefit assets that are exposed to faster growth, while hammering bonds. Bond prices move in the opposite direction of yields, meaning that recent reflation trades were also a bet on a steeper Treasury curve.

Currently, though, concerns about slower growth coupled with a Fed that’s not ready to hike soon could make a 10-year yield around 1% “achievable” within the next two months, Hu said.

The July FOMC meeting is “incredibly important because the Fed would have to signal something at this meeting in order to start tapering in September,” he said. “If they leave inflation expectations unchecked, then most likely the first action won’t be until November or December, and things could unravel very fast from here.”

Tapering as soon as possible would be a “healthy first step” at controlling inflation expectations, but won’t be enough to stop them entirely from becoming unmoored, Hu argued.

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