As the reflation trade picks up and the Fed’s attempt at quantitative easing fails market participants are beginning to chatter about the potential negative impact of rising rates. The popular explanation has been to blame the recent increase in yields on impending hyperinflation due to the endless supply of paper entering the market. Most investors are coming up with similar complex fiscal theories for the bond market’s recent collapse, but I attribute most of the move to something different: asset allocation.
At the end of last year we saw a massive rotation into safe treasuries as the stock market collapsed. At the beginning of the year I stated that TIPs would outperform treasuries as investors began to worry about inflation (though I also said these fears would become overstated). That trade has yielded roughly 25% year to date. We’re now seeing the pendulum swing to the other side. The inflation fears do not yet justify the beating in 10 year treasuries and there are no sure signs that deflation is entirely behind us. David Rosenberg breaks it down in rather simple fashion:
Well, much is being made of supply and massive Treasury issuance, and to be sure, this has accounted for some of the yield backup but not nearly all of it — after all, Aussie bond yields has soared more than 100bps despite the country’s fiscal prudence. Clearly, the ‘green shoots’ from the data has been a factor forcing real rates higher. The doubling in oil prices and the rise in other commodity prices has generated some increase in inflation expectations, and the 40%+ move in equity prices and sustained spread narrowing in the corporate bond market has triggered a flight out of safe-havens (like Treasuries), and part of the move has been technical in nature owing to convexity-selling in the mortgage market with refinancings plummeting since early April.
10 year treasury yields have jumped 1.8% since the beginning of the year while inflation has declined. Wages are flat, employment is weak and the velocity of money remains low. In the near-term, the argument for inflation is poor. Of course, if we look out long enough it’s hard to find a scenario where inflation doesn’t impact the market. As you can see in the chart below the correlation between the stock market and long bond yields have been extremely high during the credit crisis. This is mostly due to the rotation of cash between assets (as opposed to inflation and deflation).
Although yields are rising they are still extremely low in historical terms. If a 10 year treasury of 3.8% is priced for inflation then bring on the inflation. That’s the kind of inflation a stock market loves. Unfortunately for the inflationistas the bond market isn’t pricing in inflation (just yet). It’s simply reflecting the near-term change in asset allocation that is the result of the subsiding fear in the market. Of course, that’s not to say that the inflationistas will be wrong in 10 years. It just means that they’ve been wrong for the last 10 months (and likely the 10 months going forward).
Like many markets around the world, traders appear to be getting a bit ahead of themselves. Much like the oil market, where prices are soaring despite little signs of supply/demand changes and the equity markets where a v-shaped recovery is being priced in despite few signs of trend growth, the bond market is currently beginning to sniff out an inflation threat that is likely years in the future. 10 year treasuries have fallen 25% this year. This rise in yields coincides with a rising risk appetite. Rising yields don’t only precede recessions because they impede business expansion, but also because it coincides with a change in risk appetite (a contrarian indicator). In the near term rising yields aren’t necessarily an impending negative (though a prolonged trend will almost certainly derail any economic recovery). For now, it’s clear that deflation is still impacting the assets we own and until this subsides it’s likely that the treasury market will represent the sloshing of cash between safety and risk and nothing more…..