Bond Market Is Flashing Warning Signal on Trump Reflation Trade
Rising bond market seen indicating that valuations of riskier assets may be stretched
Stocks and bonds are again moving in tandem after diverging in recent months—a sign some investors may be losing faith in the so-called reflation trade.
The Dow Jones Industrial Average has soared more than 1,000 points so far this year and closed at a record of 20821.76 Friday. Bond prices, too, are rising, driving down the yield on the benchmark 10-year Treasury note to 2.317% Friday, the lowest since late November, from 2.446% at the end of 2016. Yields fall as bond prices rise.
It is a shift from late last year when investors were selling bonds and buying stocks, anticipating that large fiscal stimulus from President Donald Trump would lead to accelerated growth and higher inflation, a bet known as the reflation trade.
The new pattern is generating debate among investors.
Some money managers and traders believe that a rising Treasury bond market, often seen as a haven for investors, is a warning that valuations of riskier assets—such as stocks, corporate bonds and emerging-market assets—may be stretched. The Dow closed at a record for an 11th consecutive session Friday, the longest such streak since 1987.
James Sarni, senior managing partner at asset-management firm Payden & Rygel, is among those who bought Treasurys in recent weeks.
“The bond market is showing a more realistic view on the fiscal policy outlook than the stock market,’’ Mr. Sarni said. “The bond market has it right.”
Yield Pressure
Stocks have soared amid exuberance for President Donald Trump's policy outlook, but demand for havens has also sent Treasury yields lower. Short bets on Treasury futures have also piled up, raising the risk yields could fall further if investors exit the short positions quickly.
Yield on the benchmark 10-year Treasury
Dow Jones Industrial Average
Weekly net bets on Treasury futures
Term premium on the 10-year Treasury yield
Sources: Ryan ALM (yield); WSJ Market Data Group (DJIA); TD Securities (net bets); Federal Reserve Bank of New York (Treasury term premium)
Julien Scholnick, portfolio manager at Western Asset Management Co., said he bought Treasurys earlier this year while cutting junk-bond holdings.
“At some point the stock and bond markets need to be reconciled,’’ said Mr. Scholnick. He laid out two scenarios for bonds: the 10-year Treasury yield could rise to 2.75% or higher if “everything works out well” with fiscal policy, but the yield could fall to 2% if policy details disappoint.
Other disagree, pointing to factors that remain supportive of riskier assets: improving economic outlooks in the U.S., Europe and China; U.S. corporate earnings rebounding from a recent slump; a gradual approach by the Federal Reserve in raising short-term interest rates and continued bond buying by central banks in the eurozone and Japan.
Mr. Trump is scheduled to speak on Tuesday to a joint session of Congress. Investors will zero in on updates to his proposals for an expansive fiscal policy.
Another sign of caution on the reflation trade is the pullback of the U.S. dollar. The ICE dollar index, which measures the currency’s value against counterparts including the euro and the yen, was 101.12 late Friday, down from 103.82 on Jan. 3, the highest since 2002, according to data provider CQG.
Higher prices for stocks and bonds may also simply reflect investors’ quest for income in a very low-yield world, mirroring a trend in recent years in which both haven bond markets and riskier assets were boosted by major central banks’ unprecedented monetary stimulus.
Treasury yields, the foundation for global finance and a yardstick for valuations of riskier assets, remain relatively high compared with government bonds of Germany and Japan, increasing demand for them.
Money managers say political risk in Europe, skepticism over an imminent rate increase by the Fed and less appealing yields in other major government-bond markets are also stoking demand for Treasurys.
Many investors are not convinced the Fed will act as quickly as once thought given the uncertainty on the U.S. fiscal outlook and elections in France. Investors viewed the Fed’s minutes from its Jan 31-Feb 1 meeting, released last week, as a sign that the Fed may wait before moving rates higher again, even though Fed Chairwoman Janet Yellen signaled earlier this month that a rate increase in March was still on the table.
On Friday, the yield on the two-year German government bond hit a record low of minus-0.959%, according to Tradeweb. The yield on the 10-year German bund was 0.188% and the 10-year government bond yield in Japan was 0.06%.
Some investors are still buying risky corporate bonds, or junk debt, where the yield premium above Treasurys dropped last week to the lowest since the summer of 2014. Emerging-market stocks and bonds have strengthened this year.
In addition, investors have reduced their short bets on Treasurys, suggesting some investors returned to the bond market as buyers, causing prices to rise and yields to fall. Wagers betting on lower prices and higher bond yields, or shorts, had sent the 10-year Treasury note’s yield higher from the record closing low of 1.366% set in July.
Net wagers on higher bond yields via Treasury futures were $73 billion for the week ended Feb. 21, down from a recent peak of $100.7 billion in January, according to TD Securities.
Jack McIntyre, portfolio manager at Brandywine Global Investment Management, said bond bears risk “getting squeezed” should many dial back shorts at the same time—a scenario that could intensify the upswing in bond prices.
Even in the stock market, there have been signs of skepticism.
Utilities companies in the S&P 500, often considered bondlike because of their dividends, were up 3.7% last week, making them the best performers. Other income-heavy sectors, including telephone and real-estate shares, also posted gains. Meanwhile, financial and industrial companies in the S&P 500 lagged behind, marking a reversal from the days after the election, when investors flooded shares of banks and manufacturers while selling government bonds and their stock-market proxies.