What the reflation trade in bond markets means for duration
Volatility in government bond markets has been on the increase in 2021, leading to some large market moves towards the end of February. There is a general consensus that, supported by a global vaccine rollout, improving economy, and fewer and lighter lockdowns in the coming months, markets are seeing “the reflation trade”.
All things being equal, this should mean higher government bond yields, tighter credit spreads and higher equities. While we have seen a small amount of volatility in risk assets as we write at the beginning of March, there could be further moves to come given the speed and scale of the move upwards in government bonds.
The extent and meaning of the move
US 10-year Treasuries have added 60 basis points (bps) over the year-to-date (YTD), moving well through the 1% level that was talked about during January and currently testing 1.5%. These are levels not seen since February last year.
Whilst German yields have outperformed, and remain negative, they too have risen from a low of minus 0.6% to minus 0.35% at the end of February. UK Gilts likewise have risen and 10-year yields are at the same level (0.8%) before we all became virus and vaccine experts.1
Whilst most people probably deal in price movements rather than yield movements, to put the above in context, bond markets are on the whole down this year. Treasuries, US Credit and Emerging Market bonds are down over 3% year to date, while sterling credit and rates markets, being longer duration, are down nearer to 4%-7%. High yield is one of the few positive markets with a 1% return. Despite the “reflation trade”, inflation-linked bonds are down 1%-2% as the higher nominal yield has offset any gains driven by wider breakevens.
The move across bond markets has ruled out the probability of further quantitative easing or rate cuts and reversed some of the excess valuations caused by the supply-demand imbalance.
When does a bond sell-off become a taper tantrum?
One thing to watch for is a repeat of 2013 and 2015. We have long held the view that ‘the price of bonds is the price of money’, and to reprice US Treasuries quickly and aggressively could potentially lead to a widening of spreads further down the credit curve. All markets compete for investor capital and if Treasury yields rise and spreads tighten, then it stands to reason that marginal flows at some stage will prefer duration risk over credit risk. This is particularly the case once the government bond market prices in interest rate rises, higher inflation than people expect or, conversely, investors expect a higher default rate for risk assets than that currently priced in.
We are not there yet, but towards the end of February we started to see a weakness in risk assets leading to a painful positive correlation of most assets selling off together. Clearly, making money in that environment is very difficult.
But the medium term may have just gotten better
With yields back to early 2020 levels we are now pricing in a better growth environment and the possibility of interest rates rises earlier than the 2023 target that the US Federal Reserve has pointed us towards. At some stage this presents a buying opportunity. If yields were to continue to move higher, we would get quite excited about the medium-term prospects for bond returns.
Our core medium-term thesis has not changed: The move towards a post-COVID-19 world will not be a straightforward one. Growth and inflation should move higher but arguably this will still need to be supported by massive amounts of monetary and fiscal stimulus, and central banks will still need relatively low yields for markets to function and growth to prosper. As the bond market starts to price in higher interest rates in the very near term, an opportunity should occur to oppose that move.
Investors may want to take a more cautious approach to certain fixed income markets for the moment, but this volatility could create some interesting entry points if it continues. We will continue to watch the market closely and update investors regularly with our thoughts.
 Bloomberg, March 2021.