The bond market is torn by the potential of higher inflation and lower growth

A volatile environment for government bonds reflects a very uncertain future for the US economy, indicating both slower growth and persistent inflation.

After a surge earlier this year that spooked markets, Treasury yields fell sharply as investors moved away from worries about price hikes to look to the potential for the rapid explosion in activity. post-pandemic could start to slow down.

In the 1970s, the mix of higher prices and lower growth was called “stagflation,” a derogatory term that has garnered little attention since then, as inflation has remained under control over the past decades.

However, the word is coming up more and more these days as the growth chart gets cloudier.

“The market is trading on the topic of stagflation,” said Aneta Markowska, chief financial economist at Jefferies. “There is the idea that these price increases will destroy demand, cause policy error and ultimately slow growth.”

For her part, Markowska believes the trade that caused 10-year Treasury yields to drop from a high of around 1.75% in late March to around 1.18% earlier this week was a mistake. Yields are trading at opposite prices, so a drop there means investors are buying bonds and pushing prices up.

She sees a strong consumer and an upcoming eruption of supply, reversing the current bottleneck that pushed prices to their highest levels since before the 2008 financial crisis, as generating a lot of momentum to maintain growth. on the move without generating runaway inflation. Markowska predicts that the Federal Reserve will sit on the sidelines until at least 2023, despite recent market prices that the central bank will start raising rates at the end of 2022.

“The consensus is for 3% growth. I think we could grow 4% to 5% next year,” Markowska said. “Not only is the consumer still very healthy, but you’re going to have a massive replenishment of inventory at some point. Even if demand goes down, supply has so much catching up to do. You’re going to see the mother of all. restocking cycles. “

The bond market, which is generally seen as the more subdued component of financial markets as opposed to the go-go stock market, does not seem so convinced.

The 10-year Treasury is considered the barometer of fixed income and generally a barometer of the direction of the economy as well as of interest rates. Even with Wednesday’s yield rally, a 1.29% Treasury does not express much confidence in the future growth path.

“We believe growth and inflation are moderate,” said Michael Collins, senior portfolio manager at PGIM Fixed Income. “I don’t care about growth and inflation this year, what matters to our 10-year Treasury forecast is what it’s going to be over 10 years. And I think it’s going to come back down. the world we live in. “

The benchmark is a below-trend growth environment with interest rates well below the norm.

As the economy grew after the government-imposed pandemic shutdown, GDP has been well above the around 2% trend that had prevailed since the end of the Great Recession in 2009. The recession of Covid was the shortest on record, and the economy has rocketed since mid-2020.

But Collins expects the low-growth world to come back and investors to keep returns well within that moderate range.

“The United States will continue to be a leader of global growth and economic dynamism,” he said. “But 1.5% to 2% is our speed limit for growth unless we have a productivity miracle.”

The question which then arises is that of inflation.

Consumer prices rose 5.4% in June while the prices producers receive rose 7.3%. Both figures point to continued price pressures that even Federal Reserve Chairman Jerome Powell has admitted to have been more aggressive and persistent than he and his central bank colleagues had anticipated.

While the decline in yields indicates that some of the concerns have exited the market, any other sign that inflation will persist longer than expected by policymakers could quickly change investors’ minds.

This is because of the swirling dynamics that threaten to raise this specter of stagflation. The biggest growth concern right now is the threat posed by Covid-19 and its delta variant. Slower growth and rising inflation could be lethal to the current investment landscape.

“If the virus begins to spread rapidly again, it would dampen economic growth and prolong the inflationary supply chain disruptions that have plagued so many industries, including semiconductors and housing,” said Nancy Davis, founder of Quadratic Capital Management and portfolio manager of Quadratic Interest. Exchange traded fund against rate volatility and inflation.

“Stagflation is an even greater risk for investors than inflation,” Davis added.

Collins, however, said he viewed the current 10-year return as trading around fair value given the circumstances.

The Treasury market is often much more deliberate than its equity-focused counterpart, which can swing a lot into the headlines of both good and bad. At its current level, the bond market is cautious about the future.

With the recent sensitivity of the stock market to what’s going on in bonds, this could mean some volatility on the equity side.

“Considering what has happened over the past 18 months and the challenges much of the world is facing over the next 2-3 years, a rate of 1.2% over 10 years is understandable,” wrote Nick Colas, co-founder of DataTrek Research. “This does not mean that stocks are doomed to have a tough 2021 rest, or that a crash is imminent. It does mean that Treasuries have a healthy respect for history, especially US inflation below. the average of the last decade. “