A May 10th report from Morgan Stanley Research takes a closer look at the recent turmoil in global bond markets. MS analyst Andrew Sheets and team argue that the recent sell off in rates, and the resultant increase in bond yields, means that U.S, and European economies are gathering steam in the process of reflating.
Sheets et al. note: “G4 bond yields have risen, curves have steepened, and inflation breakevens have climbed. We think this is ‘good news’, especially seen in light of other market moves – tighter/ unchanged credit spreads tightened, energy and financial stocks outperforming, etc. – all consistent with reflation.”
The return of reflation
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The Morgan Stanley analysts argue it is the return of reflation that’s mainly been driving global bond yields higher. Although the recent rates move has been painful for many markets, the good news is that most of what we’ve seen is “consistent with the return of inflation: higher rates, steeper curves, higher inflation breakevens, credit spreads unchanged to tighter, and financial and energy stocks outperforming.”
Not only have rates moved materially higher, curves have also steepened notably, particularly in Europe. In the U.S. and UK, 2s/10s soared by almost 20 bp, while in continental Europe, it’s up by around 40 bp, hinting that the markets are beginning to price in higher future growth and inflation.
Sheets and colleagues have argued for some time that inflation risk premiums are too low. Investors are simply not being “compensated for the long-run measures of inflation, whether the past 10 years’ experience, or the past 100 years’.” Very low crude oil prices, and expectations that inflation could remain mited for much longer had held U.S. and European breakevens below target inflation rates. That situation has started to change since the beginning of the year, with 10 year breakeven up by ~20 bp and ~45 bp for the U.S. and Europe, respectively, again hinting at market’s evolving expectations on reflation.
In the economic sweet spot
The analysts argue that the big move up in rates over the last few weeks is directly related to expectations of higher growth and inflation, which should create an ideal environment for businesses. They note we’re “in the sweet spot where growth and inflation are still nascent, discouraging ‘late-cycle’ behavior. This very benign environment means that credit is still attractive from a fundamental perspective.”