After a devastating first quarter for fixed income investors that saw yields on 10-year U.S. Treasury bonds rise quickly with the reflation trade, experts are trying to explain why those yields have dropped again — and what the bond market is signalling for equities.
“The drop in yields has surprised most market participants, including us,” Richardson Wealth’s investment team admitted in a report on Monday. “While a consolidation after the 10-year [U.S. Treasury] yield rose from 60 [basis points] to 175 [basis points] was certainly warranted and largely expected, few saw yields giving back about half of their gains.”
The Richardson authors and others examined potential reasons for the bond market’s rise and found most explanations wanting.
One argument is that the recent spike in inflation is transitory and will end once supply bottlenecks are sorted out. The pre-pandemic deflationary trend, owing to high debt and aging populations, will prevail, the argument goes.
“We agree the inflationary data is about to roll over; the big question is whether it comes back down to previously low levels or remains elevated to a degree,” the Richardson Wealth authors wrote. “Yields are pricing in the former, we believe the latter.”
Scotiabank Economics vice-president and head of capital markets economics Derek Holt said that core inflation may continue to rise for the time being. Markets may be “correcting an overshoot” for high inflation lasting several years, he wrote in a report on Friday.
“The view [that inflation] won’t remain at 5% year over year forever and therefore buy bonds seems wanting for its rigour,” Holt wrote. “A sustained period of on- or just-above-target inflation over a medium- to longer-term scenario could still be possible once we move past short-sighted definitions of transitory pressures through year-end.”
Some investors are also wondering whether the rise in bond prices means the boost from the economic re-opening from the pandemic is about to fade. The spread of the Delta variant has led to Covid restrictions again in some countries, particularly those with low vaccination rates.
The Richardson authors are betting pent-up demand will drive strong economic growth for months, and Holt said most major economies are still awaiting the full services-sector rebound.
“We’re bound to see GDP growth ebb from the initial spurt coming out of lockdowns but that doesn’t mean the expansion will fizzle out,” Holt wrote.
Richardson Wealth said the bond market consolidation could be partly attributed to seasonal factors. Bond traders “take their vacations very seriously,” the report said, leading to lighter volumes and larger price moves, and bond yields often move lower in the summer.
The authors also said speculators engaging in short-covering in the futures and options markets for Treasuries could be driving up prices.
So what does the pullback in bond yields mean for equities?
Holt noted that the dividend yield on the S&P 500 is now about the same as 10-year Treasury yields, “but with expectations for further dividend hikes ahead and particularly for the recently unleashed U.S. banks.”
“It’s more likely that turbulence is being sparked by cyclical rotations, sector-specific policy challenges (e.g. so-called FANG stocks) and uncertainty ahead of the coming week’s unofficial kick-off to the Q2 U.S. earnings season,” he said.
The Richardson authors still believe in the reflation trade and said the move in bond yields has created opportunities.
“This pullback has also created some more interesting price points in many cyclical and value names, from materials to financials. We believe this will prove to be a temporary opportunity,” the report said.