Investors who missed the brief spike in government bond yields when a succession of COVID-19 vaccines aced clinical trials may regret losing the chance to get a whopping yield of 0.97% on a 10-year Treasury note.
Yields on Treasuries and other government bonds have gone back down in the meantime. That 10-year Treasury is now yielding just below 0.87%. Similarly, in the eurozone, government bonds have returned to very low yields, with even the likes of Portugal plumbing negative territory.
Reflation Trade Fizzles On Added Economic Stimulus
Stocks meanwhile have soared, as the positive vaccine news vaulted the Dow Jones Industrial Average over 30,000 in late November, for the first time. The prospect of an effective vaccine has raised hopes of booming growth for next year and boosted equities across most every sector.
Bond investors may be somewhat less optimistic than stock market investors about the vaccines. They are by nature more conservative. Their main concern is not with the economy, however, but with interest rates, which depend on inflation.
Economic boom or not, there is not much inflation on the horizon. Central banks have been unable to significantly raise inflation for more than a decade, and there is no indication their efforts are going to finally meet with success.
This prospect has taken the wind out of the sales of the so-called reflation trade. Historically, a forecast of rapid growth would mean more inflation, higher interest rates and declining bond prices (prices move inversely to yields).
Bonds, however, are caught in a Catch-22 of efforts to stimulate the economic recovery with monetary policy. Central banks have reduced benchmark rates to near-zero or below, while boosting monetary accommodation by flooding the financial system with money through quantitative easing.
But none of this is accelerating inflation. In fact, to borrow some central bank-speak, inflation expectations remain firmly anchored so that price increases are not becoming a self-fulfilling prophecy.
The five-year breakeven inflation rate, a market measure of inflation expectations, was 1.67% on Friday, while the 10-year breakeven rate was only 1.75%. Another measure, the five-year, five-year forward inflation expectation rate was only 1.83%. It barely budged from 1.81% on October 30.
Investors, in short, don’t expect inflation—regardless of vaccines or rapid growth—to reach the Fed’s target of 2% in the foreseeable future, let alone top that level so it will average 2% over time, in line with the Fed’s revised policy.
These rates represent expectations as reflected in market yields and are not forecasts. They are calculated daily and can shift as perceptions shift. But the perception right now is that nothing the Fed or central banks do is going to ignite inflation and spark higher interest rates.
There is little incentive to sell bonds. In fact, given the central bank emphasis on keeping interest rates low, there is every incentive to keep buying incrementally.
There is some question whether the Fed will decide to increase its monthly bond purchases at its December 15-16 policy meeting, or skew them to longer maturities. But policymakers are likely to wait until there is more clarity about getting people vaccinated and the trajectory of the economy before making any changes.
The European Central Bank, however, has clearly telegraphed its intention to increase its bond purchases from the €1.35 trillion currently on tap. This is keeping pressure on eurozone government bond yields.
Yields on the 10-year Italian bond briefly touched a record low of 0.551% on Monday, before ticking up above 0.58%. November inflation was negative for the seventh month in a row, with CPI falling 0.2% on the year after a decline of 0.3% in October.