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The Bond Column

The Contradiction of the Reflation Trade
Updated: 2017-10-30, 08:55:53 ET
Analyst: Pat O'Hare

The reflation trade has taken hold of the stock market again,and, to a certain extent, it has taken hold of the Treasury market.

The reflation hold on the Treasury market is plain to see atthe front end of the curve, where the yield on the 2-yr Treasury note hassoared 31 basis points since September 11. Similarly, the yield on the 10-yr Treasury note has jumped 36 basispoints over the same period.

That adjustment, however, isn't a purebred reflationtrade. If it were, the yield on the 10-yrTreasury note would be much higher and the spread between the 2-yr note yieldand the 10-yr note yield would be much steeper.

Melting Away

As it so happens, the 10-yr note yield is six basis points lessthan where it started the year while the spread of 83 basis points between the2-yr note yield and the 10-yr note yield is 42 basis points less than the spread seen atthe start of the year and 51 basis points less than its post-election peak.

The curve flattening since the start of the year has beendriven by the 2-yr note yield. It is up31 basis points since the end of 2016. The entirety of that shift has occurred over the last six weeks, too,which is when the market has priced in the prospect of a third rate hike this yearat the December FOMC meeting.

Additionally, the market seems to have acquiesced to the notion that asynchronized pickup in global growth, and the possibility of lower tax rates inthe U.S., make further rate hikes in 2018 a likely proposition.

The reflation narrative, however, seems to have gotten lostin translation at the back end of the curve where yields remain compressed.

Sure, they have risen in recent weeks, yet the narrowingspread between the 2-yr note yield and the 10-yr note yield is not the dynamicone typically associates with a view that stronger economic growth will producehigher inflation.

Party Pooper

Why is the 10-yr note yield acting like the party pooper atthe reflation party? The answer isdebatable.

  • Some think it stems from the Bank of Japan and the European Central Bank maintaining their full-fledged monetary policy accommodation, which is fueling a continuation of interest-rate differential trades.

  • Some think it is a demographic factor, with retiring baby boomers emphasizing the preservation of capital over a return on capital.

  • Some think there is some defensive-oriented gravitas to the move as market participants fret about the possibility of a big correction coming for the stock market.

  • Some think it is a simple reflection of the view that inflation is under control and will remain under control.

  • Some think it is a sign that the market believes the Federal Reserve is on course to make a policy mistake by raising rates too much, too soon, and choking off economic growth prospects.

  • And some think it reflects an ingrained view that the U.S. economy is destined to remain in a low-growth stupor for some time due to weak productivity and labor force growth.

What It All Means

The spread between the 2-yr note yield and the 10-yr noteyield hit a 10-year low last week, yet it remains a good bit away frominverting, which many market watchers construe as a harbinger of weak economicgrowth and possibly a recession.

All in all, the 2-10 spread is a peculiar relationship inthe context of a market that is courting the reflation model.

The fact that the spread has been narrowing at a time wheneconomic growth expectations are picking up is out of line with the naturalorder of a reflation trade.

What you have is a yield curve that is reflecting reflationwithout the inflation. It's a sure-mindedview of matters that could give way to quite a pain trade at the back end ofthe curve if inflation rears its ugly head.

Few people seem to be positioned for an inflation scare,which is a scary thought if their complacency ends up being misplaced.