Bond market debates how high reflation trade can boost yields

New York

THE sky may not exactly be the limit, but the early consensus in the Treasuries market is that yields are only headed higher with Democrats set to take control of Congress and the White House.

How much higher is the key topic of debate after the results of the Georgia Senate runoffs triggered a long-awaited breach of the one per cent level on the 10-year note Wednesday. Bloomberg Intelligence sees 1.17 per cent as a target, while others are looking at the March high of about 1.27 per cent. Mizuho Bank Ltd's Vishnu Varathan has a more aggressive call, seeing a 1.5 per cent to 2 per cent range as achievable in short order.

Gregory Staples at DWS sees scope for the next leg up with Friday's US labour data. A net loss of jobs, in his view, could add to the momentum for more fiscal stimulus, a scenario that markets are already bracing for under a unified Democratic government. Coming as part of a revived global reflation trade and surging inflation expectations, a gradual climb in yields may prove sustainable as it would give the Federal Reserve less reason to intervene.

"As long as inflation expectations are driving the increase in the 10-year yield, we can continue to go up from here and the Fed is not going to change that," said Mr Staples, whose firm oversaw about US$800 billion globally as of last year. "We have a little more room to go here, which could play out on Friday if we get a bad jobs report. We could break through to 1.09 per cent to 1.12 per cent."

At around 1.03 per cent, the 10-year yield has more than tripled from its record low set amid the market chaos of March. It barely reacted to the violent protests in Washington on Wednesday, a possible sign of the staying power of the reflation trade.

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For months, investors have speculated that the Fed would prevent an unruly climb in yields from crimping the economic rebound. That potential action, a reliable bid from international investors, and the backdrop of surging virus cases have kept yields in check.

The Fed is now buying about US$80 billion a month of Treasuries. The minutes of its last meeting, released on Wednesday, showed officials unanimously backed holding the pace of asset purchases steady, although a couple indicated they were open to weighting purchases toward longer maturities.

As for December's jobs report, the median forecast is for a net gain of about 62,000 nonfarm jobs. It would be the weakest since April's massive decline, and a marked deterioration could add to the case for more virus relief. Data on Wednesday showed the number of employees at US businesses unexpectedly declined in December.

Grim jobs figures released last month showed how easily bad news can perversely turn into good news in financial markets these days: US stocks climbed to then-record highs and Treasury yields jumped on expectations for more federal stimulus after November nonfarm payrolls came in well below estimates. The yield on the 10-year note climbed to 0.9842 per cent, at the time its strongest level in months.

The reflation narrative has only gained steam since then. A key measure of the yield curve is the widest in four years. And the 10-year breakeven rate, a proxy for expected inflation over the coming decade, is the highest since 2018. It's climbed above 2 per cent against the backdrop of the post-Brexit trade deal, the approval of additional virus-relief aid in the US, and the roll-out of vaccinations against the coronavirus. The US Senate runoff results are a piece of that puzzle.

Financial markets are now factoring in the possibility of US$750 billion to US$1 trillion of additional fiscal stimulus, triggering Wednesday's selloff in bonds, says Mr Staples. He's underweight 10- and 30-year Treasuries and sees potential for the curve to steepen further. He describes himself as "more cautious" on the long end, which will be prone to more swings because shorter maturities are anchored by the Fed's low-rate pledge.

BMO Capital Markets strategist Ben Jeffery takes a somewhat longer view. He says the next technical levels to watch in the 10-year rate over the next couple of weeks are 1.11 per cent to 1.14 per cent, opening gaps formed in March, along with 1.27 per cent, the intraday high on March 19. Those are the levels in which buying interest emerged at the time, and the yield began its downward trajectory to as low as 0.54 per cent over the following month or so.

Whether the Fed chooses to step in or not to contain long-end rates "will really be a function of how financial conditions perform," Mr Jeffery said. "As long as financial conditions remain easy, the Fed will be content to be patient. But a pickup in volatility will inspire a bit more urgency from policy makers." BLOOMBERG