Central banks no longer command the attention of investor sovereign bond markets. The Federal Reserve just announced a rate hike of 25bps and, subsequently, long-term rates fell. Short-term maturities are rising which should be a signal that economy is strengthening and inflation is fast approaching the target rate of 2%. Yet U.S. bond investors do not buy into that scenario.

Although the Bank of Canada has not signalled any rate hikes explicitly, market analysts are starting to muse about rate increases later this year or early 2018 in response to stronger economic growth. Even in the EU where growth has picked up some commentators are looking for a tightening of monetary conditions next year.

However, as the accompanying charts clearly demonstrate, investors in long-dated bonds are envisioning quite a different outcome. The so-called “reflation” trade, adopted after the November election, has largely been unwound. Bonds are trading as if inflation were dead. The 30-yr bond yield has tumbled and is approaching levels not seen since late fall of 2016 (Figures 1 and 2).

Figure: 1. U.S. 30yr Bond                                          Figure: 2. Canadian 30yr Bond

Readers may recall former Fed Chairman Alan Greenspan in 2005 mused about his “conundrum” whereby short-term rates rose, but long-dated yields fell. The net result was that financial conditions actually loosened, not tightened as the Fed Chairman expected. This time around the conundrum has some very plausible explanations. Bond investors have taken careful note of:

• The recent steep fall in oil prices and the continued pressure on the oil markets emanating from excess supply conditions;
• Despite near full employment conditions, wage growth has been very subdued in the 2-2.5% range and has not posed any threat to the PCE ( the preferred rate used by the Fed);
• Despite extraordinary loose monetary conditions for nearly a decade, the PCE has failed to reach the 2% target, let alone maintained that rate for any meaningful period;
• Despite positive growth, both the U.S. and Canadian economies continue to underperform and there are signs that a growth rate of 2% is about as good as we might expect; and, finally
• There continues to be a strong demand worldwide for safe, long-term assets best fulfilled by sovereign debt.

Bond market participants are asking themselves: is the Fed really going to continue hiking as they have repeatedly said? Moreover, if the Fed continues to hike rates, given the underlying conditions mentioned above, we could expect long bond yields to fall further, raising concerns that growth will slow significantly in the near term.