Why do bond prices continue to rise?
What happens in the bond market? The analysis by Alessandro Fugnoli, chief strategist of the Kairos funds
What happens? Why do bond prices continue to rise, sending real yields into increasingly negative territory? Why is this happening just as inflation is at the highest levels of the last twenty years? Does that mean the recovery is weakening? Or does it mean that the confidence that the battle between humans and viruses will be won by us is failing?
Let's start with growth. Europe is doing well, even more than expected. Asia goes like this. America was off to a great start, with a second quarter that started exceptionally strong but ended with a noticeable slowdown. On the markets, as always, it is America that sets the tone and the direction and its surprises, in the last negative weeks, influence the stock exchanges all over the world.
The American disappointment has two causes. The first is the partial waning of the demand boost compressed by the pandemic. There is a desire to make up for sadness and fear (never underestimate the American consumer's willingness to spend, says an old adage) but this does not translate into euphoria. There is still some caution, not least because the government will no longer send any more money and because the extraordinary unemployment benefits will run out in September.
The second reason is that the labor market, also in America, is traversed by all kinds of tensions. There are still many people at home but, at the same time, it is hard to find staff even paying more than before. Take the case of restaurants, forced to serve only half or a quarter of the available tables for reasons of distancing and yet forced by the new rules on minimum wages to pay more (sometimes much more) for their staff. No wonder many choose to remain closed.
However, the irregularity of growth must not make us forget that the American recovery still has very solid prospects. The second half of 2021 will be less buoyant than the first half, but growth is expected to remain at a respectable annualized rate of close to 5 percent. Europe should continue to do well and in Asia the Chinese slowdown should soon end thanks to the new pro-growth orientation of economic policy.
Why then do government bonds keep falling in yield and rising in price? The reasons are varied.
The first, which we mentioned, is the cooling of the American boom between April and June. The second is that the supply of bonds by the Treasury has dropped, which in the darkest phases of the pandemic, taking advantage of the rates dropped to 0.50 over the ten-year, had issued a trillion more than necessary and deposited the proceeds with the Fed. Treasury is drawing from its Fed account, bringing it back to normal, and therefore has less need to issue new bonds.
The (temporary) lower supply of government bonds then joined the continued demand for bonds by the Fed for Quantitative easing (120 billion, more nearly as much in the rest of the world). To this was added the demand for coverages by those who, assuming a fall in prices after inflation data, had put themselves down. In the last few days, finally, we have seen the reallocation to fixed income of positions that had been opened on the exchange on cyclical stocks and which have now been closed.
As governments move up in price, stock exchanges are reconsidering the reflation trade. Cyclical stocks correct and growth and defensive sectors are back in vogue. For now, the overall correction is contained.
To have more clarity we will have to wait for the autumn recovery. In September, as we have seen, extraordinary unemployment benefits will cease in America. At that point the labor market will be free to find a non-artificial equilibrium and we can thus measure its true strength and impact on wage inflation.
Until after the summer, therefore, the stock markets will fluctuate without a definite trend. There will be money to buy on the downside because the outlook for the second half of the year and 2022 remains good, but there will also be sellers on the upside as long as the hypothesis of a fourth wave of the pandemic remains open.
In this context, central banks are trying to stay on course. The Fed has no plans to raise rates before the November 2022 elections (let alone if the infrastructure tax package were to weaken or even run aground in Congress) and the only room for maneuver it has granted in the short term is on tapering (end of 2021 or early 2022, not much change) and, in the very short term, on the maintenance of excess liquidity, which has now exceeded the trillion dollars.
The ECB, for its part, is equipping itself with the five-year strategic review just completed with new tools to give itself more flexibility. Climate change and the operating cost of houses (not house prices, beware) as new elements for the formulation of monetary policy and for the calculation of inflation are vague and difficult to measure. In practice, they will be modeled with complex formulas that will leave the ECB more room for maneuver and the market more uncertainty (see the endless disputes on American Owners' Equivalent Rent).
It is clear that the ECB needs to break the shackles of its statute and is looking for ways to circumvent its constraints, but it is also clear that it does so with the German handbrake on, as is evident in the new formulation of the inflation target. more generous than the previous one but more limited than the American one.
In summary, there is a modest slowdown in US growth and some more pandemic risk on the one hand and lower inflation expectations on the other, while central banks basically maintain their expansionary course. The big upside may take a break, but it's not over. The next round is with second quarter earnings, which should be very good. For those with balanced positions, there is no reason to exit the market.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/perche-i-corsi-dei-bond-continuano-a-salire/ on Sun, 11 Jul 2021 05:31:12 +0000.