Bonds Lead Rethink on Reflation as Central Banks Signal Support

Investors are backtracking on reflation bets, with the bond rally extending as central banks signal continued support and stocks falling as Covid-19 variants threatened reopening prospects.

U.S. 30-year yields fell below 1.90% for the first time since February, even as the Federal Reserve discussed tapering its bond purchase program at its meeting last month. German and Chinese 10-year yields hit multi-month lows as traders positioned for a prolonged easy stance by the European Central Bank -- which raised its goal for inflation in the culmination of an 18-month policy review -- and the People’s Bank of China.

Doubts over inflation and growth reverberated across markets. Europe’s cyclical stocks led declines, while haven bids drove the Swiss franc and Japanese yen to the top of the currency leader board.

“For bond investors, the outcome is quite simply bullish for now to reflect the more dovish central bank reaction function,” said Peter Chatwell, head of multi-asset strategy at Mizuho International Plc. “This is the underlying reason for the ECB’s new framework -- running inflation hot is necessary.”

The rally across debt markets is in stark contrast to just a couple of months ago, when investor fears over soaring inflation were at their peak. While a break above 2% for Treasury yields looked imminent back then, they now stand at little over half that -- vindicating the Fed’s argument that price rises are only temporary.

The ECB’s strategy review added to bullish sentiment in bond markets, with the inflation goal raised to 2% from, close to, but below 2%, before -- and allowing short-term deviations from it. That was interpreted by some in the market as the central bank willing to keep monetary policy more supportive for longer. Meanwhile, the euro extended gains to the day’s high at $1.1868, as investors perceived the ECB’s approach to targeting inflation to be less aggressive than some may have expected.

China has signaled an even bigger shift to investors, hinting the economy needs additional central bank support, diverging sharply from discussions of tapering in the U.S.