# Inflation fears heat up in bond market as ‘reflation story’ gains ground

“There is a strong belief in the reflation story,” said Bob Tzucker, portfolio manager at Garda Capital Partners, in emailed comments.

But beyond immediate drivers, Tzucker said the Fed’s tolerance for inflation overshoots has also encouraged the bond bears. Under changes made to the Fed’s policy framework in August, the central bank would wait to see if inflation was running sustainably above its 2% target before responding.

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The Fed’s willingness to make its inflation target “more symmetric is reason enough for inflation to rise assuming that people believe they can hit the target. On that point, people are starting to believe it after several years of skepticism. The addition of strong fiscal stimulus to the already strong monetary response has started to convince investors that this time is different,” he said.

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The 10-year Treasury note yield
TMUBMUSD10Y,
0.947%
stood at a three-week high of 0.953%, up over 10 basis points in the first two days of December. .

Mirroring this rise, expectations for where consumer prices will average over the next decade among holders of inflation insurance rose to 1.84%, the highest since July 2019.

Outside of market-based measures, inflation expectations among manufacturers have also been on the rise, indicating businesses and households were penciling in higher prices after a slew of announcements from vaccine makers beginning last month showing significant progress toward the development of a weapon against the COVID-19 disease.

Zhiwei Ren, a portfolio manager at Penn Mutual Asset Management, said the flurry of bond-market activity in the past two days reflects how yields and inflation expectations were starting to catch up with the buoyant mood in stocks.

Equities rallied in November, with gains tied largely to vaccine developments. The Dow Jones Industrial Average
DJIA,
+0.19%
topped the 30,000 milestone for the first time as it logged its best monthly performance since January 1987, while the S&P 500
SPX,
+0.12%
saw its strongest monthly gain since April and posted its best November since 1928.

Bond traders appeared content to wait for the end of November before betting on a steeper yield curve, analysts said, in the belief that long-term yields were set to climb as the widespread distribution of vaccines delivered a more robust economic recovery.

“Once the market starts to move, people don’t want to miss the trade. They want to pile on,” said Ren.

But others doubted the recent bond-market selloff, and accompanying rise in yields, could be sustained.

Analysts at Rabobank noted that the $900 billion, bipartisan aid spending bill proposed on Tuesday, one of the cited triggers for the yield jump, fell far short of the trillions proposed by Democratic lawmakers before the election.

They noted less than half of the yield surge on Tuesday was driven by higher inflation expectations, with the rest coming from investors demanding more yield in compensation to offset the uncertainty of how a near-term coronavirus aid package could influence the Fed’s actions.

“The argument that a stimulus package should underpin the reflation trade, meanwhile, is certainly logical but arguably seems a little stretched,” they said.

Amid the frenzied trading in U.S. government bonds, the surge in inflation expectations, at least for this week, hasn’t ignited gains in an obvious candidate to benefit from higher prices — Treasury inflation-protected securities.

The iShares TIPS Bond exchange-traded fund
TIP,
+0.02%
tracking the performance of a basket of Treasury inflation-protected securities was slightly negative this week. The ETF, however, is up 8.1% year-to-date.

Indeed, Anders Persson, chief investment officer of fixed income at Nuveen, said he expected inflation to gradually tick up next year as the economy normalizes, but that intensifying price pressures might be hard to come by.