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What is the bond market telling us?

There is currently much head-scratching in financial markets with regard to one of the most stable relationships in financial history: the falling of bond prices when consumer prices rise. The link seems to be broken at the moment.

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Key takeaways:

  • The US bond market’s reaction to record-high consumer inflation is raising questions.
  • Investors are pricing in peak inflation as well as peak growth and that is supportive for defensive stocks.

Inflation has risen to record-high levels in recent months, and the 10-year US bond yield has fallen to a fresh five-month low. What is the reason for the rally in US Treasuries? Obviously, investors believe that peak growth and peak expectations are already behind us. The US Federal Reserve’s (Fed) shift towards earlier-than-expected rate hikes has removed fears that inflation may run out of control, and falling purchasing managers’ indices from record-high levels support the case for decelerating economic growth. This is a normal mid-cyclical consolidation driven by base effects and most likely set to continue at least until Q1 2022.

The big question is: What will happen thereafter?
Much depends on the longer-term inflation outlook. Our economists and most other market pundits argue that the surge in inflation is temporary, but how long exactly is ‘temporary’? The answer will notably depend on the strength of second-round inflation effects. Wage growth and worker shortages will be crucial indicators to watch out for. Further coronavirus-induced supply-chain disruption in emerging markets is another factor to consider. Then there are rent prices, which make up ca 20% of the core inflation index targeted by the Fed. In April, US house prices rose 14.6% against the same period last year, while rents are still below pre-pandemic levels. There may be some upside as well.

What does all this mean for financial markets?
We believe it is too early to buy back cyclicals and value stocks. We prefer defensive growth stocks for the time being. However, the risk that the market will have to extend the time period that defines ‘temporary’ has increased. If that happens, the market will also have to reassess the assumption of ‘eternally friendly’ central banks. The reflation trade may have another leg, but it would be premature to anticipate this today. We recommend a more prudent approach to equity markets, and we recommend defensives and high-quality growth names.

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