A funny thing happened on the way to the great reflation trade that, just a few weeks ago, was the dominant market theme. The reflation trade was supposed to get out in front of strong inflationary pressures as well as the sooner-than-expected withdrawal of some of the Fed’s extraordinary monetary policy support. The yield curve was supposed to steepen, with long-term rates like the 10-year Treasury note going through two percent for the first time since early 2019. Instead, what we have gotten over the second half of June and all of July has been a head-scratching, curve-flattening rally in the long end of the yield curve. What the heck happened?
Many market pundits have blamed a worsening global and domestic COVID outlook as the new Delta variant wreaks havoc, worsening the outlook on inflation and economic growth. From a macro perspective, this makes some sense, however, it is a little hard to believe that sentiment could have changed so quickly and decisively. After all, risk markets such as stocks and high-yield bonds barely flinched on bad COVID news and instead continued to rally almost unabated. We realize, many times, the Treasury market gets the bad news ahead of stocks, but we do not think this is one of those instances. Many times, head-scratching bond market rallies (or sell-offs) have a lot more to do with trading flows as opposed to market outlooks. Think of it like the micro look as opposed to macro. Often, the trade flows from different sectors of the market affect one another like a string of dominos. We think that is what has happened in the Treasury market.
It is hard to say what exactly stopped the 10-year Treasury’s yield from ascending toward two percent at the end of May. We can see that the U.S. Dollar, as measured by the ICE U.S. Dollar Index (DXY), appreciated nearly 3% from the end of May to the end of June. There has definitely been capital flight to the U.S. Dollar as our vaccine program has significantly outpaced all of our trading partners. Some of this capital goes to the safety of U.S. Treasuries. Additionally, data has been showing that foreign central banks have continued to step up their purchases of U.S. securities. Finally, for global money managers, Treasury yields, adjusted for currency hedging, have become attractive to Japanese, German, and British government debt. There is a good sense these large entities stepped up their buying of Treasuries as well. This was probably enough to throw a monkey-wrench into the rate sell-off that most of the market predicted.
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