There is still no way to avoid the great bond market conundrum. Why do yields continue to fall, along with inflation breakevens, on the back of U.S. consumer price numbers that are the highest in decades? Yes, there’s a good chance that inflation will prove transitory, for reasons I went through exhaustively earlier this week, and on many other occasions before that. But for now, inflation is a fact, and there are plenty of economists and analysts who expect it to establish itself. Why is the bond market growing more confident that inflation will be avoided?
The decline persists, with the 10-year bond yield now below 1.3%. Meanwhile, the spread between two- and 10-year yields, arguably the clearest bond market judgment on the prospects for reflation, is back down to 106 basis points, having canceled out its rise since February and fallen below its 200-day moving average. As this chart of the yield curve shows, this rarely happens unless there is a clear flattening trend, and is a remarkable outcome when inflation is rising:
There are any number of good technical reasons why people might have bought bonds recently, which I have covered. What fundamental reasons might there be for shifting your money to bet on deflation? Louis Gave of Gavekal, who freely admits that (like me) he had expected yields to keep rising, offered this summary of the most plausible three reasons:
• The second is the perception that policy in the US may actually turn less dovish, and at an earlier date, than initially thought. After all, President Joe Biden has scaled back his infrastructure plans from US$2.2 trillion to less than US$1.2 trillion being spent over a longer period, while the Federal Reserve has begun to sound less dovish (with fears that the Jackson Hole confab for central bankers in August could signal a more hawkish shift).
• The third reason is a fear that China’s attempts to cool down its economy could have a deflationary impact on the world. The last of these seems to offer the best explanation of recent market behavior.
The second is important. The Georgia senatorial elections in the first week of January sparked a big move forward in the “reflation trade” as they opened the chance of more expansive U.S. fiscal policy. Now, with the Biden honeymoon over, markets may be over-compensating. Big presidential initiatives in their first year tend to go down to the wire—just look at the Trump tax cut, which appeared dead in the summer of 2017, or Obamacare eight years earlier.
As for the delta variant, while it should alarm all of us, it’s not clear that it would be enough to have some of the macroeconomic effects we are seeing at present. As Gave points out, it might lead to a weaker dollar (which is what happened with the first wave of Covid), and yet the dollar is rallying. It might also exacerbate supply disruptions and make inflation worse.
Instead, he was probably right in singling out China for most attention. Last week’s cut in banks’ required reserve ratios, as I noted earlier this week, is the kind of thing that only happens if the authorities are worried about the economy. And we now have more Chinese data. Retail sales are up 12.1% year on year, and perhaps more importantly have risen at an annualized rate of only 5.32% over the two years since June 2019. GDP growth is 7.9%; over the last two years, the annualized rate is slightly higher, at 8.2%.
If we look at the data on a two-year basis, to try to cancel out the extraordinary happenings since the beginning of last year, we get a picture of a China growing a tad disappointingly, but not obviously in the kind of trouble that would justify tumbling Treasury yields. Here, Societe Generale SA shows retail spending and household incomes on a two-year basis:
Overall, this suggests a gradual slowing in the pace of growth, after pandemic effects are excised, which is problematic for the notion of a grand reflation trade, but also does little to justify an all-out bet on deflation and Japanification. As for the influence of Chinese (or other foreign) buying on Treasuries, it is much less important than in the “conundrum” era, when it was popular to blame a Chinese “saving glut” for low yields. As this chart from Capital Economics Ltd. shows, that no longer holds:
One other interesting point demonstrates that the decline in bond yields isn’t just some technical quirk. The equity market is also positioning in exactly the way you would expect if it was bracing for a sustained period of low yields. On a global basis, and not just in the U.S., valuations are increasing for stocks that benefit most from falling bond yields, and decreasing for those that perform best when yields are rising. The following chart is from Andrew Lapthorne, chief quantitative strategist at SocGen:
• The first is fears that the spread of the Covid delta variant will postpone a full reopening of the global economy. 
