Friday's Market Minute: Reflation Reality

U.S. stocks jumped to record highs with retail sales and weekly jobless claims data signaling an accelerating recovery in the U.S. economy in both GDP and inflation. With all this positive news, one of the more confusing dynamics now is yields on 10-year Treasury notes dropped the most in a single day since February instead of rising in response to evidence of the improving economic trajectory. Treasury yields have fallen over the past week but are still up substantially so far this year. The days of improving economic data triggering a bond market sell-off may be tentatively gone as solid macroeconomic and bank earnings data was surprisingly not accompanied with the steepening of the yield curve.

When the bond market responds contra to logic and expectations, skeptics of the stock market point out that the move in bonds may possibly signify a safe-haven bid away from equities due to fully priced-in expectations of the reflationary fiscal forces deployed in 1Q. The bond market may have read the March retail sales data as artificially-boosted consumption from trillions in government stimulus funds coursing through businesses and households. Supply chain disruptions and higher prices from lows reached early in the pandemic may have also been priced into bonds, as inflation growth is likely to slow as time passes and those challenges are resolved. Others suggest the drivers of the bond market rally had little to do with investors’ expectations over economic growth, but rather short-term traders quickly moving out of their lucrative year-to-date short bond positions.

The theme of inflation and never-ending supply of printed money to buy bonds has certainly jolted interest-rate-sensitive equities and the holders of bonds this year, but the reality may lie in the fact that inflation is a gradual process and the multi-decade secular downtrend in rates remains intact. The economy is still not operating at full employment, and capacity utilization at 74.4% is 5.2% below the average from 1972 to 2020. Therefore, the bond market reaction to positive economic data may simply reflect sustained inflation over long periods of time will require much more than the Fed’s maintenance of a low-rate environment to avoid jeopardizing markets and the economic recovery.

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