Almost every corner of the global  market has recently signaled that a faster recovery is on the way, after the Covid-19 vaccines proved effective this month. Economically sensitive stocks, industrial metals, crude oil, all have rallied hard. But the story is different for the US Treasury. The vast US government bond market is usually highly sensitized to prospects of growth, and especially to what is known as the “reflation trade”- the bet that the economy will rebound quickly. When bonds are sold in anticipation of new issues on the horizon, it is known as a reflation trade.

Faster growth almost always means higher inflation, higher yields and so lower Treasury prices.

This time, the bet has changed, with investors starting to accept that the reflation trade would not bring, actual inflation. The prospect of vaccines returning life across the world to normal has injected wild hope into many of the least-popular assets.

Cyclical stocks sensitive to the economy have done very well, while defensive stocks able to ride out recessions are in less demand. In particular, some of the stocks that won as people stockpiled groceries and worked from home have lagged behind badly this month.

The message is clear, things are looking better. But the Treasury market seems to have missed the memo. Yields leapt on the day of the announcement of the Pfizer vaccine, but have since fallen back, with the 30-year yield, usually supersensitive to growth prospects, lower than at the start of the month, along with the 10-year.

This unusual divergence is not because the bond whisperers think that the vaccine does not matter. It is about the Federal Reserve and inflation, or rather the lack of it. After a decade when faster growth, low unemployment, and zero interest rates did nothing to spark inflation, many no longer expect even extraordinary Fed action to push up prices faster.

Inflation prospects have barely budged, despite the boost to the economy a vaccine is expected to bring. The implied inflation rate calculated by comparing yields on Treasurys and on Treasury inflation-protected securities for the five years starting in five years’ time has risen only to 1.83% from 1.81% at the end of October, still below the 1.92% reached last month, the highest since August last year.

With inflation off the agenda, investors think that the Fed will stamp down hard on any rise in yields, because of the drag on growth from higher borrowing costs. Rick Rieder, chief investment officer of global fixed income at BlackRock said, “The Fed just overwhelms everything.”

The recently concluded Presidential election could still be having an effect, too. Investors had prepped for a Democratic sweep of Congress, but barring an unlikely double Democratic win in Georgia runoff votes, Republicans will control the Senate. Investors think that means much lower fiscal stimulus, and so more monetary stimulus, probably in the form of yet more buying of long-dated bonds. Traders are unwinding their previous bets against bonds and readying for more Fed buying keeps yields down.

Inflation-free growth would be good not only for investors but for everyone, as it allows interest rates to stay low even as the economy accelerates. But there are a couple of reasons for caution, as Treasurys and everything else could come back in line. First, if the market sniffs any hint of price rises, there could be an explosive rise in bond yields that hurts stocks and other assets as investors return to their normal inflation expectations. Second, this month’s huge gains by economically sensitive assets assume a quick vaccine approval and deployment. If the massive logistical challenge takes longer than hoped, it would leave investors free to focus on the economic damage from a rapidly worsening third wave of coronavirus in the US.

(Source: WSJ)

The author is a student member of Amity Centre of Happiness