Inflation bets run out of steam as global bonds rally

A global bond rally this week suggests the anxiety over inflation that had gripped markets this year has begun to subside, with investors shrugging off figures on Thursday showing US price rises accelerated further.

US government bond prices briefly fell in the wake of the release of figures showing consumer price inflation climbed to an annual rate of 5 per cent in May — the highest since 2008. But the moves proved shortlived, as markets resumed a rally from earlier in the week that has pushed the benchmark 10-year US Treasury yield to its lowest since early March at 1.48 per cent. 

The recent price gains, which also swept up other government bonds around the world, were driven mostly by a decline over the past month in expectations of longer-term US inflation. That suggests investors are coming around to the Federal Reserve’s view that the current spike in price gains will not last.

“With bond market goggles on there is no inflation, it seems,” said Padhraic Garvey, Americas head of research for ING.

Reflecting that, 10-year US break-evens, a closely watched gauge of the level of inflation priced in over the next decade, have fallen to 2.32 per cent from the eight-year high of 2.55 per cent hit last month.

“My sense more broadly is that we have passed the peak of the narrative of rising inflation and we now have more bets on transitory inflation over the coming months,” said Guy LeBas, chief fixed-income strategist at Janney Capital Management. 

Investors say there has been little in recent economic data or Fed policy statements that would explain this reassessment of the long-term prospects for inflation, although a lukewarm US labour market report last week has damped some of the exuberance over the speed of the recovery from the pandemic in the world’s largest economy. 

Instead, they point to a build-up in bearish bets against US Treasuries and other government bonds in the rush out of lockdowns in the first three months of this year. That left many investors needing to buy bonds when markets turned against them.

“A lot of this is about positioning,” said Mike Riddell, a fund manager at Allianz Global Investors. “As Treasuries start rallying people get out of their short positions, which drives the rally further.”

Some analysts have looked across the Atlantic for a catalyst. European government bonds have chalked up strong gains over the past few weeks after European Central Bank officials publicly talked down speculation that they would soon be dialling back stimulus efforts. The ECB confirmed at its policy meeting on Thursday that it will maintain the current pace of its bond purchases. 

German 10-year yields on Thursday sank to minus 0.26 per cent, their lowest in more than six weeks. “We have one major central bank that’s going to be providing more liquidity than markets thought a month ago,” said Peter Chatwell, head of multi-asset strategy at Mizuho. “That acts as an anchor for other markets, including Treasuries.”

Despite the pullback in inflation expectations and bond yields, some investors are wary about calling time on the market’s inflation scare.

Many have become more willing to shrug off higher-than-expected inflation surprises like Thursday’s because much of the spike is accounted for by the “base effects” of a recovery from last year’s slump, according to Sonal Desai, chief investment officer for fixed income at Franklin Templeton. But she argues their resolve, and the Fed’s, may be tested if the inflationary spike continues over the coming months.

“I think it might stick around for a bit longer than anticipated,” Desai said. “I think there could be more going on than base effects. The question remains: how does the market think the Fed will react? Next week’s Fed meeting will be very interesting.”