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Reflation in ambush!

Market Insights 20.07.2021


July 2021


Laurent Denize

Laurent Denize,

Falling bond yields have restored relative value to equities. The upcoming earnings sequence will be crucial in providing the pulse for the coming months.

Let's face it, at the beginning of the year, we did not expect the US 30-year yield to fall so quickly below 2.0% after having hit a high of 2.45% in March 2021. Reflationary expectations are wavering, but are they completely called into question?

A rapid decline in long rates

What are the reasons for this rapid decline in long-term rates and the potential scenarios for the rest of the year? The sharp drop in yields and the flattening of the yield curve is explained by 3 factors:

  • Weaker than expected economic data. Indeed, the weakening of the data fueled the idea that the U.S. has reached its growth peak and that the slowdown could push yields down. This growth rate is not sustainable: after averaging nearly 9.5% real GDP growth in mid-2021, we expect U.S. growth to slow down in late 2021 and into 2022. However, our chief economist forecasts real GDP growth of 5.1% in 2022, which is still well above potential.
  • There was a feeling that the Fed would reduce its asset purchase program more quickly than expected and consequently raise rates as early as 2023. However, the Fed did not suddenly become "hawkish" at the June 16, 2021 meeting. And it is unlikely to become less accommodative until the unemployment rate falls below 4%.
  • The unwinding of speculative positions on rising rates. The market data does indeed indicate that investors were over-positioned (to rising rates) and that the buying of shorts exaggerated this move. We do not see an immediate catalyst to bring yields back to their June levels (a 10-year at 1.55% on average), but high valuations and "cleaned up" positions should favor a return to the mean.

In the next few weeks, the 10-year US yield could rebound on the back of a new tightening in the labour supply and substantial progress in financing infrastructures. In the nearer term, a heavy offering of Treasuries will be put on the market during the week of 12 July, including 58 billion dollars in three-year bonds and 38 billion dollars in 10-year paper. How the market reacts to such heavy supply will be an initial indicator of investor sentiment.

As things currently stand, we advise you to holding onto short 10-year Treasury positions and 2y/7y steepening strategies. We are less confident in the long section of the curve.

What about reflation?

Although inflation breakeven points’ predictive character is open to debate, they do offer a good basis of analysis.

The decline in breakevens in the past two weeks has probably been exaggerated by the technical decline in nominal yields. We expect these to turn back up in the medium term, alongside the increase in real yields and still robust growth. Economic surprise indices have turned down and are at their lowest local levels. June inflation continues to surprise on the upside. The strengthening in the report’s basic components could serve as an upward catalyst for medium-term inflation expectations. The reason for this is that labour supply is likely to increase at the end of summer with the end of federal unemployment programmes, and that could have a positive impact on wages in the coming months. Moreover, housing inflation could continue to rebound in the coming months, thus supplying a solid backing and sustainability to inflation at healthy levels, even if transitional components pull back.

Continue overweighting equities

Ultimately, falling bond yields have restored relative value to equities. The upcoming earnings sequence will be crucial in providing the pulse for the coming months. Earnings growth forecasts have been raised by 15 percentage points since January (from +32% to +47% in Europe between 2020 and 2021e), fully in line with equity market gains. The equity markets are still expensive but are being driven by consistent fundamentals. Potentially positive surprises in earnings and macroeconomic statistics could provide new momentum to cyclical equities in the coming months. We are far from ruling out this scenario. We don’t agree that the value vs. growth rotation is over. However, the coming market cycle will probably take the form – until yearend – of a long mountain stage, in which we continue to “attack at the bottom of climbs”.


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