Treasury Market’s Reflation Pricing Is On Hold, For Now

After rebounding sharply from pandemic lows, the 10-year Treasury yield is nearly back to levels that prevailed before COVID-19 began to roil the global economy in early 2020. But the 10-year rate has been in a holding pattern for the past two months, raising questions about what happens next (SPTL).

Markets are forward-looking and so the Treasury market began pricing in recovery and reflation in 2020’s second half. The repricing ran its course in 2021’s first quarter and remains on hold as investors consider the outlook for inflation and economy.

The rear-view mirror certainly paints a bright picture. Economic growth accelerated to 6.4% gain (annualized real rate) in this year’s first quarter and is on track to run even hotter in Q2. The Atlanta Fed’s GDPNow model, for example, estimates output will surge to a red-hot 10.1% pace (based on the May 18 estimate).

A stronger run of growth in Q2 will keep the recovery narrative humming, but such a pace isn’t sustainable and probably will mark a peak for the cycle (ignoring the off-the-charts 33% surge in 2020’s Q3 due to the one-time bounce-back effect from the depths of the pandemic).

Even if the economy tops out in Q2, the expansion will remain healthy for the foreseeable future. But as US government stimulus spending fades, economic activity will continue to normalize — a shift that the Treasury market seems to be anticipating.

Using the 10-year rate as a guide, the Treasury market is pricing in a future of moderating growth and inflation data. Incoming numbers, as always, could upend this implied forecast, but for the moment the market seems to be anticipating the US will move closer to picking up where it left off before the pandemic struck.

The wild card is inflation, which rebounded sharply in April, based on the consumer price index. The great debate is whether this surge is temporary or the start of an enduring run of hotter inflation. A convincing answer won’t be known for months. Meanwhile, rest assures that every monthly CPI update will be closely read and debated as the crowd looks for fresh clues, starting with the June 10 release of May inflation data.

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Disclosures: None.

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