The second half of 2016 witnessed the rise of the “reflation trade”, a trend that accelerated after the U.S. election. The thesis: The global economy was finally breaking out, inflation was firming and bond yields would be rising as bonds are sold. While parts of this trade remain in place, other manifestations have reversed, including bond yields. After today’s turmoil, U.S. 10-Year Treasury yields are currently around 2.21%, below where they started the year.
What happened to the bond market meltdown and the thesis of rising rates?
Growth has yet to break out
By now everyone is aware of another disappointing first quarter for the U.S. economy. In part, a weak Q1 can be attributed to lingering seasonal quirks in the data. Still, the simple truth is that there is not much evidence that the economy is surging. Yes, job growth remains strong and consumers and small businesses optimistic. However, outside of the labor market actual economic activity remains modest. Adjusted retail sales are growing at roughly 4.5% year-over-year, in-line with the post-crisis average. While investment activity improved in Q1 and manufacturing is crawling back from its recession, industrial production remains muted. Finally, economic data are not keeping up with lofty expectations. The U.S. Citigroup Economic Surprise Index, which measures how actual economic data releases compare to expectations, is back into negative territory and at its worst level since October (see below).
Inflation and inflation expectations remain modest
The funny thing about the reflation trade is we’ve yet to experience the inflation. In fact, realized inflation is decelerating: Core consumer prices, excluding food and energy, are down to 1.9% year-over-year, the slowest rate since late 2015. The Federal Reserve’s (Fed’s) preferred measure of inflation, core personal consumption expenditure (PCE), is at a one-year low of 1.60%. Crude oil prices, a big driver of short-term inflation, are below year ago levels as U.S. shale producers make up the supply OPEC has removed. The net result: 10-year TIPS inflation expectations have slipped to 1.90%, close to where they were in the immediate aftermath of the election.
Yields remain lower just about everywhere else
While U.S. investors, particularly those dependent on income, bemoan the lack of yield, pity the investor in Europe or Japan. German 10-year yields are still below 0.50%, while similar maturities in Japan and Switzerland yield 0.03% and -0.09% respectively. With the exception of Australia and New Zealand, the U.S. has just about the highest long-term rates in the developed world. For many foreign investors, the U.S. remains an attractive place to invest, keeping bond prices high and yields suppressed.
I still believe yields will creep higher this year. The Fed is likely to continue to lift short-term rates while increasing tightness in labor markets should nudge wages higher. That said, it is not obvious that the secular factors that have been suppressing bond yields—slow nominal gross domestic product, demographics, regulatory pressure and even lower yields outside the United States—allow for a melt-up in rates. When we look back on 2017, we may very well see another year in which rates defied expectations.