Reflation Trade Gets Shot in the Arm With Rate Hikes in Focus

A wave of reflation bets sweeping across global markets is prompting traders to brace for an end to the low interest-rate regime earlier than expected.

The ramp-up in inflation expectations intensified a selloff in Treasuries sending the gap between the 5- and 30-year yields to the widest since October 2014 and bringing forward expectations for U.S. rate hikes to as early as mid-2023. That’s reverberating across assets from credit to emerging markets, and emboldening commodity bulls who are betting on a super-cycle to drive a surge in prices including for copper.

Reflation Trade Gets Shot in the Arm With Rate Hikes in Focus

The trade is picking up momentum on prospects for pandemic-relief spending, rising inflation expectations, and a higher real yield that strips out price gains to reflect a pure read on growth prospects. In response, traders across the globe are setting their sights on the prospect of policy tightening by the Federal Reserve and other central banks -- however unlikely in the near term -- as the pace of bond yields’ ascent raise concerns over its impact on risk sentiment and financial conditions.

“The duration spoiler we worried about is upon us,” John Velis, a BNY Mellon strategist, wrote in a client note. “Despite signs of inflation across the supply curve, the Fed will not dial back policy accommodation until at least late 2022, and might even impose yield curve control before then as yields drive higher.”

Credit Vulnerability

Ten-year Treasury yields climbed as much as six basis points to 1.39%. Money markets are pricing in the first Fed 25-basis-point rate hike for around mid-2023, versus early 2024 earlier in February.

Credit markets would be among the most vulnerable, as rising government rates more than offset the shrinking risk premiums in company debt. Total corporate bond returns are down almost 1.9% this year, according to Bloomberg Barclays indexes.

Credit’s vulnerability to rising yields increased during the pandemic, as companies exploited low interest rates to raise funds that wouldn’t have to be repaid until the virus was a distant memory.

“Last summer, being short or bearish U.S. and global government bonds was an obvious trade -- many markets were pricing in substantial global reflation, but government bonds everywhere were essentially pricing in a great depression,” said Mike Riddell, portfolio manager at Allianz Global Investors. “Now it’s getting increasingly hard to argue that government bonds are expensive.”

Emerging Markets

The pace of Treasury yields’ ascent hit emerging markets, where currencies from the Mexican peso to the Turkish lira and South African rand suffered declines of more than 1% on Monday.

If U.S. Treasury yields continue to rise, “central banks in emerging markets may need to hike rates to stem inflationary pressures coming from weakening currencies,” Per Hammarlund, chief emerging-markets strategist at SEB AB in Stockholm, wrote in e-mailed comments. The Fed “will need to let market participants know how they plan to prevent long-term yields from rising too fast,” he added.

In Australia, reflation trades reached a fever pitch that will be hard for global policy makers to ignore. Ten-year Australian yields climbed the most since March 2020, while benchmark three-year yields inched further above the Reserve Bank of Australia’s 0.1% target.

The moves were more muted in Europe, where German and Italian rates steadied after rising as much as 3 basis points. After the yield surge this year, there’s a risk investors may be overdoing the prospects for a full economic recovery even as nations intensify their vaccination roll-outs.

“The market needs to be cautious about getting too over its skis on this as there is a lot of spare capacity and unemployed people that need to be reabsorbed,” said Charles Diebel, who manages about 4.5 billion euros ($5.5 billion) at Mediolanum in Dublin. “I would think we are getting to the point where risk assets start to take notice.”

©2021 Bloomberg L.P.

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