A Few Brave Traders Bet Against Bond Doom, Defying Deflation

(Bloomberg) -- Bond yields and inflation expectations have hit record lows as the coronavirus spreads and central banks take emergency steps to stem the economic damage. The gloom has gone too far -- and the market is looking mispriced, according to some brave souls on Wall Street.

The speed of the outbreak and the challenge for governments to contain it, coupled with an oil shock, have left the developed world contemplating a deflationary spiral. And that makes hedging a recovery -- whether it’s V-, U- or L-shaped -- an increasingly attractive proposition.

BlackRock Inc. has long been overweight U.S. inflation-protected bonds, and it’s not budging now as it reckons the slowdown will set the scene for a spirited rebound. Merian Global Investors bought “cheap” inflation protection this week in expectation the situation will be so dire that governments will do whatever it takes to bring economies back on track.

BlueBay Asset Management is on the sidelines for now, but looking for an entry point before a recovery in the second half of the year.

In the ongoing market turmoil and a rush to draw comparisons with the financial crisis, such optimism stands out. But comparing current conditions to the post-Lehman era may actually bolster the glass-half-full case.

“The bond market currently appears to be screaming a very different message than it did in 2008,” Jim Paulsen, chief strategist at Leuthold Weeden Capital Management LLC wrote in a note. “Both then and now there was and is panic. But in 2008, the bond market was dramatically raising the real bond yield on an economy in peril. Today, by contrast, the bond market is lowering the real yield, thereby aiding the economy.”

Based on Paulsen’s analysis, a deflation-risk message -- like the one that presaged a recession in 2008 -- occurs when inflation expectations fall faster than nominal bond yields, leading to a rise in real yields. This time, it’s the other way around. Since early November, the 10-year Treasury yield has declined by more than 100 basis points, while inflation expectations, as proxied by the breakeven rate, dropped about 70 basis points.

The upshot is a market repricing growth, not pricing in deflation.

Scary Charts

None of which changes the optics: A chart of inflation expectations right now is a scary thing.

The five-year/five year forward inflation swap rate fell to record low this week in the U.S. and Europe. Bloomberg’s recession model is now flashing 53% probability of a recession in the world’s biggest economy.

“The intrinsic value in the TIPS market has gone up over the past three weeks because the market’s reacting pretty negatively to the risk of a growth shock,” Bob Miller, head of Americas fundamental fixed income at BlackRock in New York, said in an interview last week. “We like TIPs. They’re substantially cheap to realized inflation.”

Miller recently added to his overweight position in inflation-protected securities, he said.

At the same time as the protection looks cheap, there are green economic shoots to cling to. The latest data suggested China may have passed its worst point of contagion. The Federal Reserve and the Bank of England gave markets an emergency 50 basis-point rate cut each, and there are fiscal pushes from the U.S. to U.K., Hong Kong to Thailand.

It’s not enough to make an optimist of everyone. Three months ago, Jason Bloom wanted to sprint to his desk to buy inflation-protected bonds when no one at the conference he attended thought price growth would pick up. Now you’d struggle to meet a bigger bear on the outlook.

“Risk is now disinflation, or even deflation,” said Bloom, a strategist at Invesco Advisers Inc. “People are going to stop traveling, stop going to restaurants, stop going out to shopping malls because of the virus outbreak, and there is little that fiscal or monetary stimulus or cheap oil can do to change that in the near term.”

Bloom said he is underweight inflation-sensitive exposure as economic growth momentum turns negative. He reckons a kind of cyclical recovery that would drive inflation higher won’t happen in the next 18 months.

Confusing Markets

Bloom’s volte-face and the conflicting market views perfectly encapsulate the headache confronting investors. Neither money managers nor strategists are well-versed at modeling the rate of a viral infection, so no one has a clue on the outlook.

The uncertainty is on display in the market. The biggest exchange-traded fund tracking inflation-protected Treasuries attracted the most cash since 2016 last week, but lost a chunk of that Tuesday.

For Mark Nash, the head of fixed income at Merian Global Investors, the most important thing to bear in mind in this situation is that no one should underestimate what governments can and will do to help the market and the economy. And that’s his reason not to be too pessimistic.

“Who will stand in the way of virus relief?” said Nash. “It’s a political suicide.”

To contact the reporters on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net;Emily Barrett in New York at ebarrett25@bloomberg.net

To contact the editors responsible for this story: Sam Potter at spotter33@bloomberg.net, Sid Verma

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