Bonds Lead Rethink on Reflation as Central Banks Signal Support

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Investors are backtracking on reflation bets, with the bond rally extending as central banks signal continued support and stocks falling as Covid-19 variants threatened reopening prospects.

U.S. 30-year yields fell below 1.90% for the first time since February, even as the Federal Reserve discussed tapering its bond purchase program at its meeting last month. German and Chinese 10-year yields hit multi-month lows as traders positioned for a prolonged easy stance by the European Central Bank -- which raised its goal for inflation in the culmination of an 18-month policy review -- and the People’s Bank of China.

Doubts over inflation and growth reverberated across markets. Europe’s cyclical stocks led declines, while haven bids drove the Swiss franc and Japanese yen to the top of the currency leader board.

Bonds Lead Rethink on Reflation as Central Banks Signal Support

“For bond investors, the outcome is quite simply bullish for now to reflect the more dovish central bank reaction function,” said Peter Chatwell, head of multi-asset strategy at Mizuho International Plc. “This is the underlying reason for the ECB’s new framework -- running inflation hot is necessary.”

The rally across debt markets is in stark contrast to just a couple of months ago, when investor fears over soaring inflation were at their peak. While a break above 2% for Treasury yields looked imminent back then, they now stand at little over half that -- vindicating the Fed’s argument that price rises are only temporary.

The ECB’s strategy review added to bullish sentiment in bond markets, with the inflation goal raised to 2% from, close to, but below 2%, before -- and allowing short-term deviations from it. That was interpreted by some in the market as the central bank willing to keep monetary policy more supportive for longer. Meanwhile, the euro extended gains to the day’s high at $1.1868, as investors perceived the ECB’s approach to targeting inflation to be less aggressive than some may have expected.

China has signaled an even bigger shift to investors, hinting the economy needs additional central bank support, diverging sharply from discussions of tapering in the U.S.

Doubling Down

The outlook has forced well-known bond bulls like HSBC Holdings Plc’s Steven Major to double down on bullish forecasts, seeing Treasuries finishing the year at 1% from a rate of around 1.25% currently. In Europe, German 10-year yields fell as much as four basis points to -0.34%, while those on their French peers hovered close to 0%.

Cyclical and value sectors were the biggest laggards on the Stoxx Europe 600 index on Thursday, with miners, banks and automakers each dropping more than 2% as investors shifted out of sectors that may suffer from slowing growth and recovery.

“Risks are increasing and, given the good performance in the first half of the year, more and more investors are getting nervous,” said Andreas Lipkow, a strategist at Comdirect Bank AG. “The negative news flow is becoming too much.”

Yet, UBS Global Wealth Management strategists said the drop in yields and the rotation away from cyclical sectors are likely to be reversed. Strategists led by Mark Haefele see the retreat in oil and factors pressuring yields as temporary, and noted that the latest economic data point to supply disruptions rather than weaker growth.

In currencies, investor demand for safety has translated into the yen and Swiss franc leading gains among the group-of-10 against the greenback this month.

“It seems that this position unwind is occurring at the worst of times: when macro expectations are being pared back, and when market liquidity is drying out ahead of the summer,” wrote ING Groep NV strategists led by Padhraic Garvey. The “price action suggests more reflation trades are being shed.”

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