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Global Stagflation vs Reflation debate: What the bond market knows that we don't?

We do see some pressure on global yields emanating from growth and policy normalization and see gradual EM spillover and higher risk premia as fears of delta variant subside in the medium term.

August 01, 2021 / 12:34 PM IST

The recent slump in the developed market (DM) yields led by US Treasury (UST) seems counter-intuitive given the factors that drove the uptick in yields early this year have played out as expected — super-inflation, strong cyclical growth, and hints of policy normalization. While the Covid Delta variant may have added some uncertainty recently, a meaningful economic impact is yet to be seen. The vaccination rate is high and hospitalization rate is still way low and activity/mobility on net remains very healthy in DMs. However, the yield curve flattening has been alarming other risky assets, like equities and commodities. Thus the reflation trade is getting hit somewhat as the growth acceleration narrative that drove much of the financial markets in CY21 is showing early signs of fraying with mixed outcomes.

Certainly, the mixed data flow and delta variant scare kicked off the fall, the exaggerated move has gone beyond fundamentals and mainly reflected lighter net supply ahead of debt ceiling, aggressive technical positioning and short covering in a low-liquidity environment. In fact, the Commodity Futures Trading Commission (CFTC) data indicates net investor positioning remains neutral to mildly bearish. We wonder what new information has been discovered that was not known when 10year yields ticked up to 1.75 percent in March 2021. The market's quest for "narrative fitting" tends to be futile sometimes. If treasury market is pricing/correcting Fed's mistake of being hawkish in/since June, the Treasury curve should have technically bear-flattened, not bull-flattened, as it prices in more rate hikes and a policy mistake. More importantly, if the Fed mistake narrative were true, other macro markets like equities and credit should have responded with weakness as well.

So does the Reflation trade still have steam? Hell, yeah!

a) We think this current fall in yields appear dislocated from fundamentals and from its fair valuation. While the best of reflation does look to be behind us it is far too early to fade reflation trends. Thus cherry-positioning in equities and other risk assets is still a good bet. We see UST yields at 1.65 percent plus by end-CY21.

b) Still in the early stages of the post-pandemic recovery, not in the late cycle: The world hasn't fully reopened yet. US growth is possibly peaking but will still be expected to remain around 1.5pt above trend through CY22. Even after leveling off, US macro indicators are consistent with a robust recovery, further bolstered by the continued tightening of the labor market. We reckon Delta variant remains a tactical headwind in the US and Europe equities but won’t derail the momentum meaningfully.

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c) Fundamentals of Demand-Supply: Easing overhang of debt ceiling resolution and a possible passage of Biden infrastructure package would likely push yields higher in the coming months. With the Fed’s reduced UST demand by next year amid quantitative easing (QE) tapering, yields are directionally poised to rise.

d) Global stance: The softer Chinese monetary policy stance amid tighter credit impulse is significant and is supportive of the reflation trade, further buoyed by European Central Bank's (ECB) effective move towards more tolerant inflation.

What does it imply for emerging markets (EM) and India yields?

EM yields have been falling since March, amid generally softer monetary policy stance as the region faced a more severe Covid-II wave. The slump in DM/US yields post June hasn't really percolated down the EMs commensurately, with each EM depicting its own domestic dynamics, led by policy reaction functions, inflation and demand-supply dynamics. This also reflects that risk rotation/growth fear is still not a widespread global theme. However, we do see some pressure on global yields emanating from growth and policy normalization and see gradual EM spillover and higher risk premia as fears of delta variant subside in the medium term.

Madhavi Arora is the Lead Economist at Emkay Global Institutional Equities

Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Madhavi Arora is the Lead Economist at Emkay Global Financial Services.
first published: Aug 1, 2021 12:34 pm

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