Anyone expecting a return engagement from the bond market vigilantes this year has been disappointed. To find any sightings of them, you’d need to send out an expeditionary force.

Inflation, as measured by the Consumer Price Index (CPI), has been running at 5.4%, or 1.3% above economists'consensus, for several months. Yet the bond market remains unfazed, even though most experts who determine bond prices have been wrong repeatedly in 2021.

“Three inflation prints have been off the charts” and the consensus in the bond market keeps growing more confident they agree with the Fed that inflation will be “transitory,” Erik Weisman, MFS Investments chief economist and portfolio manager, noted. Given the yawning chasm between perceived consensus and reality, one would think markets might reflect a higher degree of uncertainty.

Instead, yields on 10-year Treasury bonds have stood in the 1.3%-1.4% area for most of the last month. Part of this is driven by Fed policy. More observers are questioning why the central bank is applying remedies it used after the housing crisis a decade ago, like buying mortgage-backed securities, when there is a housing boom underway.

Real yields, which are indexed to non-seasonally adjusted CPI, are running at about negative 101 basis points, or 1.01%, and real GDP is expected to rise 7% this year, Weisman continued. Nominal GDP could surge 10%.

Many other economists and market strategists have been surprised by the apparent disconnect between the bond market and economic reality. On a recent Friday morning following a strong employment gain of 850,000 new jobs, JP Morgan Asset Management's chief market strategist David Kelly said the rally in 10-year U.S. Treasury bonds seemed somewhat incongruous. This morning BlackRock CEO Larry Fink told CNBC that inflation is unlikely to be transitory.

The bond market isn't buying into a narrative that many Americans are feeling every day in the supermarket and the gas pumps. “It defies logic,” Weisman says. “It should be in no way obvious that the market is right.”

He and other bond market professionals think it is perfectly plausible that yields on 10-year Treasurys could rise to 2.50% in the next 18 months, as many bond market professionals expect.

After all, at 2.50% those yields would be in the bottom decile of historical payout levels over the last 70 years, Weisman said. Yet were that to happen, those same 10-year government bonds would lose 8% or 9% in value. Accepting the current coupon of 1.33% for the next decade seems like meager compensation for the risk, he added.

But long-dated government bonds have been falling ever since the economy reopened and started displaying robust growth this past spring. Have the bond market vigilantes simply rolled over and waved the white flag?

It would appear that two decades of slow growth and low inflation have left them conditioned to accept that the new normal outlined by Pimco a decade ago will last forever. But Weisman points out the pandemic recession was different from the Great Financial Crisis in almost every way.

The U.S. economy emerged from the 2007-2009 recession with bank and household balance sheets in tatters. Both groups engaged in sustained deleveraging, while the federal government embraced austerity. The upshot was it took years to narrow the output gap, Weisman said.

Contrast that world to today’s environment, where households are just starting to leverage themselves up like it’s 2002. The current housing boom is characterized by short supply and big down payments. But in late 2022, the U.S. economy could close the output gap as it approaches full employment.

Some may write off today’s inflation picture as the byproduct of temporary supply-chain bottlenecks, commodity market imbalances and generous stimulus checks that are about to expire. In reality, it’s more complicated.

The labor market is the diametric opposite of what it was 10 years ago. Since the pandemic began, Amazon has hired about two million workers starting at $16 an hour or more. Other employers have found themselves in stiff competition for a shrinking pool of workers. The upshot is that the effective minimum is $15 an hour and people who once had low-paid jobs in the hospitality and retail sectors are finding more attractive offers higher on the employment ladder.

Weisman doesn’t doubt that inflation will be lower 12 months from now than it is today. But he suspects it will last a little longer and settle somewhat higher than the 2.0% long-term rate the Fed is projecting.

Specifically, he expects it will run at a 2.4% clip during the remainder of this expansion after things settle down. That's about 0.7% higher than the last business cycle.

That’s hardly cause for alarm, but it does have significant implications for bond pricing that markets seem to be ignoring. Weisman’s relatively benign outlook doesn’t assume some kind of exogenous shock that could send prices higher next after price increases stabilize in a post-reopening 2022.

He acknowledges that money supply growth will normalize next year, but that could be offset by a much higher velocity of money than we’ve seen in decades. “You’ve created a lot of kindling,” he said. “Does anyone have a match?”

What happens when the Fed starts to withdraw stimulus is anyone’s guess. Corporate America has been “selling a lot of equities, but equities don’t fall,” Weisman noted. The Fed and others have been buying a lot of bonds, but rallies for most fixed-income securities have been anemic. “It’s too asymmetrical,” he said.

What could the market be pricing in? There are several possibilities in his view. One scenario is that the market is reasoning that the Fed will have to raise rates and “things will peter out” and the economy will enter a recession in 2024 or 2025.

Another possibility is a much more robust scenario, one not cited by Weisman, is that forces like technology and globalization that caused disinflation for the last three decades will reassert themselves and trump shortages in the labor and commodity markets.

But there are other ramifications if current market conditions remain in place. Specifically, Weisman said, if negative real rates become a permanent fixture on the financial landscape, allocating capital will become a daunting challenge.