E Bonds And The Re-Inflation Trade Re-Examined

Following close on the heels of the elections in Georgia last week the so-called “reflation trade” was the topic of the day. Analysts argued that the Democrats’ control over the presidency and both houses of Congress will allow Biden to push through a very aggressive stimulus package. A flood of new debt issuances will be needed to cover increases in deficit financing. Not hesitating for a day, bond investors steepen the yield curve such that the 10-year yield broke through 1% and the 30 yr hit 1.87% by week’s end (Figure 1). Similarly, real interest rate bonds, TIPs, went deeper into the red as investors sought protection against inflation exceeding the 2% Fed target rate.  Wall Street forecasters were warning bondholders that the 10-year rate would likely hit 1.8% or higher with the anticipated economic growth surge in late 2021. Investors were betting on a perfect combination of near-zero short-term rates (a sign of ample liquidity) and rising long term rates (a sign of economic revival) to support equities.

Figure 1 US Treasury Yield Curve, Current and Year Ago


How realistic is this assumption that the yield curve will continue to steepen? A number of factors will keep long term rates from continuing to climb to wit:

  • The US Treasury market has already the highest interest rates of any of the major industrialized countries; Germany’s 10-year rate is minus 0.5%, the UK’s is 0.2% and Japan’s is held in check at zero by the Bank of Japan’s QE policy; a widening spread will attract international investors to buy Treasuries and drive US rates lower;
  • The Fed has essentially painted itself into a corner, declaring it will not raise rates for at least three years, even though inflation were to exceed its 2% target; this implies that real long-term rates will remain negative and this is bullish for long-dated assets;
  • The US output gap or deflationary gap is still quite wide, estimated to be 3%; US job growth is clearly stalling; this gap will continue to anchor the Fed funds rate and any widening at the long end will just provide a buying opportunity---- there are decidedly limits to how much steepening the market can endure before investors rush into to take advantage of the spreads;
  • The Fed has a great influence on the shape of the yield curve through its QE buying program; it would not look favorably on long term rates blowing out at a time that the Treasury is looking to finance a higher Federal deficit; while the Fed will not explicitly say it will adopt a form of yield curve control, it is very mindful of the importance of keeping long rates down for this reason.
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