Bond Market’s Stalled-Out Reflation Trade Needs Actual Inflation

The reflation trade that dominated the start of 2021 in the bond market has taken a breather, leaving investors bracing for a key set of data in the week ahead that has the potential to reaffirm expectations that price pressures will build as the economy rebounds.

All eyes will be on Tuesday’s release of the U.S. consumer price index for March, which is expected to show a significant jump. The number will likely be distorted by the huge slump in year-earlier figures at the outbreak of the pandemic. But traders may be reluctant to dismiss an acceleration -- as they did to some extent with Friday’s stronger-than-projected producer price data -- if there’s a growing sense that it marks the beginning of a trend.

The statistics come at a crucial time for bond bears betting on reflation. Market measures of inflation expectations, fueled by ultraloose Federal Reserve policy and immense amounts of fiscal stimulus, have stalled near multiyear highs and have yet to be backed consistently by actual data. The same goes with gauges of the yield curve, which have retreated from recent peaks. It’s not just bond positions at stake: Without follow-through from data, bets on Fed tightening as soon as late 2022 may fade, potentially sapping demand for the surprisingly resilient dollar.

Bond Market’s Stalled-Out Reflation Trade Needs Actual Inflation

“We don’t have strong reflation-trade momentum at the moment because people are waiting for more data,” said Daniel Tenengauzer, head of markets strategy at Bank of New York Mellon Corp. “As the data comes in, we are probably going to see the reflation trade play out again more strongly” toward the middle of the year.

Tenengauzer says every inflation reading counts from this point because “the longer inflation stays at 2.5%,” an annual CPI reading last seen before the pandemic took hold, “the more underwater you are from holding fixed income.”

Ten-year Treasury yields rose Friday, while finishing below the day’s high, after the PPI report showed a 4.2% increase from March 2020. Although it was relative to a period when the pandemic caused price pressures to crash, it was the biggest annual gain since 2011. The benchmark yield has retreated since approaching 1.8% last month, the highest since January 2020.

There are strong arguments on both sides of the inflation debate as the market moves from a phase where it was driven by rising expectations for price pressures, to one where investors are seeking backup from the data. There’s also a view that expectations for growth, not inflation, may end up dominating the narrative for Treasuries later this year, through higher real yields.

Inflation ‘Psychosis’

Fed Chair Jerome Powell, who’s scheduled to appear on “60 Minutes” Sunday and will also speak Wednesday, has said any pickup in inflation will likely be temporary. Hoisington Investment Management Co., meanwhile, said in its latest quarterly report that inflation fears are a “psychosis” that will fade.

But that doesn’t mean that a jump in the consumer price index won’t spook bond investors at least briefly. The March figure is forecast to show a year-over-year increase of 2.5%, which would be the highest since January 2020 and above every point on the yield curve. It’s a development that may also undermine stocks.

“The market’s been pricing in a reflation theme already since the second half of 2020, but strong, realized prints would almost add fuel to the fire,” said Shahid Ladha, head of Group-of-10 rates strategy for the Americas at BNP Paribas SA.

That, in turn, would produce upside risk to yields on intermediate maturities because of the possibility that the Fed might have to tighten sooner than expected, he says.

Investors are also tasked with absorbing a combined $120 billion of coupon auctions next week, including 30-year debt, as they ponder the inflation question. While expectations for an elevated CPI reading may be a concern, the past month has shown that there’s sufficient demand for Treasuries, which should help “grease future bond auctions,” Tenengauzer said.

What to Watch

  • Economic calendar:
    • April 12: Monthly budget statement
    • April 13: NFIB small business optimism; CPI; average earnings
    • April 14: MBA mortgage applications; import/export prices; Fed’s Beige Book
    • April 15: Jobless claims; retail sales; Empire manufacturing; Philadelphia Fed business outlook; industrial production; Langer consumer comfort; business inventories; NAHB housing index; TIC flows
    • April 16: Building permits; housing starts; University of Michigan sentiment
  • Fed calendar:
    • April 12: Boston Fed’s Eric Rosengren
    • April 13: Philadelphia Fed’s Patrick Harker; San Francisco Fed’s Mary Daly; Richmond Fed’s Thomas Barkin; Atlanta Fed’s Raphael Bostic, Cleveland Fed’s Loretta Mester and Rosengren at event on racism and the economy
    • April 14: Dallas Fed’s Robert Kaplan; Powell speaks to the Economic Club of Washington; Beige Book; New York Fed’s John Williams; Vice Chair Richard Clarida discusses new policy framework; Bostic
    • April 15: Bostic; Daly; New York Fed Executive Vice President Lorie Logan; Clarida; Mester
    • April 16: Kaplan in two appearances
  • Auction schedule:
    • April 12: 13-, 26-week bills; 3-, 10-year notes
    • April 13: 30-year bonds
    • April 15: 4-, 8-week bills

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