Inflation has always been a serious influencer upon bond-market behaviour. The reasons are simple: higher inflation erodes the fixed return you receive from a bond and prompts central banks to raise rates. It is therefore strange that, despite recent higher inflation bond yields have fallen (returns have risen) over the last couple of months.
Why might this be?
Government-bond markets have been the best performing bond markets recently, despite higher-than-expected inflation numbers and central banks talking about tapering quantitative easing. Yields have fallen – for example, the US 10-year yield is down from 1.74% at the end of March to around 1.30% now.
When investors are confused about markets and react illogically to the economic data, there are the inevitable stories about the less well-known fundamentals of supply and demand imbalances and market positioning. On the demand/supply point, it is well known now that in the US the Federal Reserve has been buying up all the net supply of Treasuries, and that investors have also been buying back Treasuries ever since.
Moreover, if you dig a little deeper into the economic and monetary data, you can see that the reflation story is not all one-way traffic. Some forward-looking economic indicators have been rolling over (from very high levels) and the ‘transitory inflation story’ is well known, so some investors appear to be taking the view of why worry about it for now?” In our view this does not, however, rule out the possibility of greater volatility ahead.
Paul Brain, investment leader fixed income team, Newton Investment Management.
Doc ID: 663807