Reflation Trades Survive Despite Mind-Bending Trump Twitter Run

(Bloomberg) -- Bond traders are holding tight to the idea that the U.S. economy will keep rebounding and inflation will accelerate even after President Donald Trump nixed talks for a major fiscal stimulus package.

With polls and betting websites showing increased odds of a presidential election victory by challenger Joe Biden -- and also the prospect that the Democratic Party could control Congress -- markets are factoring in an even bigger fiscal bump down the track despite Trump putting the brakes on a pre-election package.

That, combined with indications that the president might be open to some individual measures, helped push investors back into favored reflation trades on Wednesday. Long-term Treasury yields jumped, reversing nearly all of their move from late Tuesday, when a mind-bending few hours of tweets from Trump first dashed prospects of any fiscal stimulus and then opened the door to some support. Share prices also recovered some ground, while demand for havens such as the Japanese yen waned.

“The market realizes that whoever wins, more than likely Biden now, there is going to be significant stimulus and additional infrastructure spending,” Andy Brenner, head of international fixed income at National Alliance, said in a note.

The sharp shift in the long end drove the yield curve steeper, with the gap between 5- and 30-year yields rising as high as 126 basis points on Wednesday. That’s close to the 2020 high reached in June which was the steepest since 2016.

“The higher likelihood of a blue sweep scenario seems to be the more dominant narrative,” said Credit Suisse rate strategist Jonathan Cohn, referring to the prospect of Democrats controlling the presidency and both chambers of Congress. He has previously looked to fade any uptick in yields ahead of the November ballot, but the changing election calculus suggests it would be “prudent” to lean toward a steepening of the curve.

Traders have been marking up where they see the rate of consumer price inflation heading. The 10-year breakeven rate -- a market-based measure of average inflation rates over the next decade -- sits around 1.70%, having risen in six of the past eight sessions.

Some analysts also predict that in the absence of sufficient fiscal support this year, the Federal Reserve might look to do more if the economy requires additional help.

“Fiscal failure would force the Fed to consider strengthening support across quantitative easing and credit easing,” Evercore ISI vice chairman Krishna Guha wrote in a note to clients.

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The prospect of additional help from the Fed, and the central bank’s willingness to go above its 2% inflation target, has helped to drag down option-market pricing of deflationary scenarios. The market is instead turning more to the idea of an inflationary overshoot during the next five years. While the five-year dollar inflation swap is close to its pre-pandemic level, a 2% cap option on this maturity -- which pays out if inflation is above that level -- costs twice as much.

Minutes of the Federal Open Market Committee’s most recent policy meeting -- which took place before all the most recent fiscal developments -- indicated some further discussion of the central bank’s bond-buying program might be in the offing. The readiness of some officials to examine the program signals they’d be open to altering or increasing the purchases -- perhaps before the end of the year -- as a way to further bolster the economy’s slowing recovery from the Covid-19 pandemic.

“More buying by the FOMC will clearly support the markets,” said Phil Toews, chief executive of New York-based Toews Corp., which manages $1.9 billion. “But it will have to be a big move to make a real difference, which isn’t likely until we see more deterioration in the financial markets or further erosion of job growth.”

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