Reflation Trades Face Reality Check With Fed’s New Goal in Doubt

(Bloomberg) -- The bond-market reflation bets that have proven popular in the recovery from the March market cataclysm now face tougher odds.

Positions favoring a steeper yield curve and inflation-protected securities got a boost last week when Federal Reserve Chair Jerome Powell announced the central bank is shifting its 2% inflation target to an average over a so-far unspecified horizon, implying greater tolerance for an overshoot.

There will be no repeat of the recent record Treasury supply this week to support steepener bets by pressuring long-end yields higher. And market-implied inflation expectations such as the breakeven rate over the next decade are closing in on 2020 highs despite the pandemic stalking the global economy.

“To go meaningfully higher from here in terms of market pricing of inflation, you need to see the real economy cooperate,” said Anne Mathias, senior rates strategist at Vanguard Group Inc. For the 10-year breakeven rate to return above 2%, she said, “it’s not just the Fed talking, the economy’s got to be walking.”

The rise in the market’s inflation gauges since March partly reflects faith in the Fed’s aggressive steps to tackle the economic fallout from the pandemic. But it’s also about the market shedding the risk of deflation, rather than a conviction that inflation will surge above 2% -- especially since concerns about a Fed-induced bout of high inflation following the 2008 crisis proved to be unfounded.

Heavy investment flows into Treasury inflation-protected securities have helped too, by easing the liquidity premiums from the height of the crisis. July and August have seen the strongest monthly inflows to the largest U.S. exchange-traded fund for TIPS since 2016, according to data compiled by Bloomberg.

These investments are at worst a cheap hedge -- or possibly timely insurance against an inflationary storm to come. The latest data suggest the latter is a long way off. The Fed’s preferred measure of price pressures showed a year-over-year inflation rate of only 1%, and a slowing monthly pace. Any stall or retreat in inflation expectations may mean market confidence in the Fed to boost price pressures was short-lived.

The end of this week brings the latest Labor Department jobs report, which economists expect will show the unemployment rate is still close to double-digits.

“That would indicate there’s still slack in the system,” said James DiChiaro, a portfolio manager at Insight Investment. “And although the Fed may be indicating they’ll allow inflation to run a little bit hotter in the future, we still have to get there first.”

DiChiaro is also skeptical about the curve’s chances of getting much steeper in the near term. The five- to 30-year spread has already risen a quarter percentage point this month, closing in on the year’s high of 129 basis points. But that move has been fueled in part by a series of record Treasury auctions -- including a couple of sloppier-than-usual sales of longer-dated debt. The coming week is the first in a while with no new notes or bonds for the market to digest.

Moreover, the month-end index rebalancing is expected to bring the largest extension for the Bloomberg Barclays U.S. Treasury Index since 2009, forcing heavy purchases of U.S. government debt among benchmarked funds.

Of course, these reflation trades could get a new lease on life soon enough, with the Fed’s next policy decision in mid-September. A further commitment to ultra-low interest rates for longer, with no additional hint of long-end asset purchases, could lend a hand. A long-awaited agreement on fiscal stimulus could be another catalyst. But the ultimate boost will depend, as Powell himself repeatedly says, on the path of the virus and progress on a vaccine.

Investors don’t have to wait long to hear more from the Fed on its shift. Fed Vice Chair Richard Clarida is set to speak on Monday on the central bank’s new framework.

What to Watch

• The economic calendar
  • Aug. 31: Dallas Fed Manufacturing activity
  • Sept. 1: Markit U.S. manufacturing PMI; ISM manufacturing; construction spending; Wards vehicle sales
  • Sept. 2: MBA mortgage applications; ADP employment; factory orders; durable/capital goods orders; Fed’s Beige Book
  • Sept. 3: Challenger job cuts; nonfarm productivity; jobless claims; trade balance; Bloomberg consumer comfort; Markit U.S. services /composite PMI; ISM services
  • Sept. 4: Nonfarm payrolls
• The Fed calendar:
  • Aug. 31: Fed Vice Chair Richard Clarida; Atlanta Fed’s Raphael Bostic
  • Sept. 1: Fed Governor Lael Brainard
  • Sept. 2: New York Fed’s John Williams; Cleveland Fed’s Loretta Mester; Beige Book; San Francisco Fed’s Mary Daly
  • Sept. 3: Chicago Fed’s Charles Evans
• The auction calendar:
  • Aug. 31: $54 billion 13-week bills; $51 billion 26-week bills
  • Sept. 1: $30 billion 119-day cash-management bill; $30 billion 42-day CMB
  • Sept. 3: 4-, 8-week bills

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