# Analysis-Reflation rethink sends bond markets into a spin
Author:  Pal Sinha, Barnali 
Author URL: https://financedigest.com/author/pal-sinha-barnali
Published: 2021-07-07
Category: INVESTING
Category URL: https://financedigest.com/category/investing
Meta Title: Bond Market Rally Signals Economic Growth Peak and
Meta Description: Discover why sovereign bond markets are surging, indicating a peak in economic growth and transitory inflation concerns. Stay informed with the latest analysis.
URL: https://financedigest.com/analysis-reflation-rethink-sends-bond-markets-into-a-spinhtml

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By Dhara Ranasinghe

LONDON (Reuters) – 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](https://www.financedigest.com/shares-drop-yields-shoot-up-after-u-s-inflation-data.html "Shares drop, yields shoot up after U.S. inflation data") of 2021. The rally accelerated on Wednesday, with [yields falling](https://www.financedigest.com/stocks-climb-yields-fall-with-dollar-on-inflation-data.html "Stocks climb, yields fall with dollar on inflation data") to just below 1.3%, their lowest in over four months.

British gilt yields fell to a similar low while [German](https://www.financedigest.com/german-yields-steady-spreads-tighten-after-recent-repricing.html "German yields steady, spreads tighten after recent repricing") 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](https://www.financedigest.com/shares-slip-yields-rise-as-u-s-data-sparks-rate-hike-concerns.html "Shares slip, yields rise as U.S. data sparks rate hike concerns"), softer-than-expected economic data and concern about COVID variants.

Push past the noise and the real message from sovereign [bond markets](https://www.financedigest.com/stocks-up-bond-yields-fall-as-markets-mull-a-fed-policy-pause.html "Stocks up, bond yields fall as markets mull a Fed policy pause") — 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](https://www.financedigest.com/bank-of-england-raises-rates-to-3-5-says-inflation-has-peaked.html "Bank of England raises rates to 3.5%, says inflation has peaked") and inflation is transient,” said Guy Miller, chief market strategist at Zurich Insurance Group.

The turnaround in [bond markets](https://www.financedigest.com/global-bank-bonds-claw-back-losses-as-markets-rout-eases.html "Global bank bonds claw back losses as markets rout eases") 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](https://www.financedigest.com/hopes-of-slowdown-in-rate-hikes-bolster-shares-ahead-of-u-s-gdp.html "Hopes of slowdown in rate hikes bolster shares ahead of U.S. GDP").

But even with that shift, the [Fed does not expect to start raising rates](https://www.financedigest.com/stocks-euro-gain-amid-divergent-fed-ecb-rate-hike-outlooks.html "Stocks, euro gain amid divergent Fed, ECB rate hike outlooks") until 2023 and, like other major central banks, has stressed it will look past any short-term rise in price pressures.

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](https://www.financedigest.com/wealth-management-consultant.html "Wealth management consultant") strategist Frederik Ducrozet.

The rush back into [bonds comes](https://www.financedigest.com/analysis-watch-out-risk-assets-the-rout-in-bonds-is-coming-your-way.html "Analysis-Watch out risk assets, the rout in bonds is coming your way") as data reinforces the view that economic growth may have peaked.

(Graphic: [Citi’s economic surprise index](https://www.financedigest.com/london-tops-colliers-cities-of-influence-index.html "London Tops Colliers Cities of Influence index"), https://fingfx.thomsonreuters.com/gfx/mkt/nmopaxbjbva/Citisurprise0707.png)

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](https://www.financedigest.com/6-months-to-go-until-brexit-and-investor-sentiment-remains-bold.html "6 months to go until Brexit and investor sentiment remains bold") 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](https://www.financedigest.com/global-equities-gain-as-rising-bond-yields-pressure-gold.html "Global equities gain, as rising bond yields pressure gold") in line with a recovering economy – forcing many to liquidate those trades, pushing yields lower still.

(Graphic: Short positions in the US [bond market](https://www.financedigest.com/us-stock-futures-bonds-rally-as-markets-flirt-with-fed-pause.html "US stock futures, bonds rally as markets flirt with Fed pause"), https://fingfx.thomsonreuters.com/gfx/mkt/oakvedjqbpr/USpositioning0707.PNG)

THE REAL THING

Plenty of investors, including the world’s biggest [asset manager](https://www.financedigest.com/asset-managers-on-alert-after-whatsapp-crackdown-on-banks.html "Asset managers on alert after ‘WhatsApp’ crackdown on banks") BlackRock, have been bearish on Treasuries. BlackRock reiterated its bearish bet on Wednesday. Yet yields have seen a steady 50 bps decline [since March](https://www.financedigest.com/the-nasdaq-100-on-track-to-have-its-best-week-since-march-2010.html "The Nasdaq 100 On Track to Have its Best Week Since March 2010").

Explanations for that slide vary; some cite demand from Europe and Japan where [central banks](https://www.financedigest.com/analysis-china-central-bank-under-pressure-to-ease-is-hemmed-in-by-inflation-fed-jitters.html "Analysis-China central bank, under pressure to ease, is hemmed-in by inflation, Fed jitters") are resolutely dovish. Others point to the liquidity swirling around the U.S. financial system as the Treasury [spends its cash balance and the Federal Reserve sucks up $120 billion](https://www.financedigest.com/chipmaker-infineon-ready-to-spend-billions-on-acquisitions-ceo.html "Chipmaker Infineon ready to spend billions on acquisitions – CEO") of bonds each month.

But it may also be that despite the seemingly vibrant economic recovery, [bond markets](https://www.financedigest.com/how-will-the-ecb-contain-fragmentation-risk-in-euro-area-bond-markets.html "How will the ECB contain fragmentation risk in euro area bond markets?") have had doubts on the outlook; yield declines are being led by “real” or inflation-adjusted borrowing costs, ING Bank analysts said in a note.

U.S. 10-year real yields have slumped to minus 1%, the lowest [since February](https://www.financedigest.com/dollar-heads-for-first-weekly-gain-since-february.html "Dollar heads for first weekly gain since February"), while German real yields are at three-month lows.

It could be that the 1.77% U.S. 10-year nominal [yield level touched in March will remain this year’s high as more of the “reflation” bets](https://www.financedigest.com/traders-ramp-up-bets-on-75-basis-point-ecb-sept-hike-bond-yields-jump.html "Traders ramp up bets on 75 basis-point ECB Sept hike, bond yields jump") are forced to unwind, according to Mike Sewell, a portfolio manager at T.Rowe Price.

There is still some potential for that [trade to reengage but that is more a 3rd or 4th quarter](https://www.financedigest.com/bnp-paribas-first-quarter-revenue-beats-as-trading-outperforms.html "BNP Paribas first-quarter revenue beats as trading outperforms") potential. Right now the reflation trade is not dead but it’s certainly hibernating,” Sewell said.

Two other [factors may be contributing](https://www.financedigest.com/factors-contributing-to-negligent-security-situations.html "Factors Contributing To Negligent Security Situations") to the nervousness.

First, China, the world’s number two economy, also this [week released data](https://www.financedigest.com/wall-st-seen-steady-ahead-of-inflation-data-fed-later-in-week.html "Wall St seen steady ahead of inflation data, Fed later in week") showing services sector growth slowing to a 14-month low. That, some analysts believe, is a blueprint for how [developed economies](https://www.financedigest.com/arrested-development-what-banks-dont-get-about-the-api-economy.html "Arrested development? What banks don’t get about the API economy") will fare.

Second, more countries — including [China — are seeing a resurgence](https://www.financedigest.com/618-shopping-festival-in-china-makes-a-resurgence.html "618 shopping festival in China makes a resurgence") in COVID-19 caseloads and worries are growing about new, potentially more infectious variants.

The [Delta variant](https://www.financedigest.com/oil-prices-fall-as-delta-variant-spread-weighs.html "Oil prices fall as Delta variant spread weighs"), now dominant in many countries, including the United States, is more easily transmitted than earlier versions of the coronavirus.

The muscle memory of markets is that governments will lock down again if they see cases rise, which means slower growth and that we are caught in a loop,” said Charles Diebel, [head of fixed income at Mediolanum International](https://www.financedigest.com/the-hidden-financial-woes-of-international-students-heading-for-the-uk.html "The Hidden Financial Woes of International Students Heading for the UK") Funds.

(Graphic: [Bond yields](https://www.financedigest.com/stocks-fall-bond-yields-rise-as-focus-shifts-to-fed-rate-outlook.html "Stocks fall, bond yields rise as focus shifts to Fed, rate outlook") tumble, real and nominal, https://fingfx.thomsonreuters.com/gfx/mkt/dgkvlrqdavb/bonds0707.png)

(Reporting by Dhara Ranasinghe, Additional reporting by Sujata Rao and Karin Strohecker in London and David Randall in New York; Editing by Sujata Rao and Nick Tattersall)


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