GOVERNMENT BONDS RALLY AS REFLATION TRADE APPEARS TO RUN OUT OF ROAD

GOVERNMENT BONDS RALLY AS REFLATION TRADE APPEARS TO RUN OUT OF ROAD

This week the markets came down with a nasty bout of reality as investors decided the whole idea of a new roaring ‘20s maybe wasn’t the nailed- on certainty they thought. The spread of the Delta variant, delays in new US infrastructure spending and a more hawkish US Federal Reserve have all served to dampen down growth and inflation expectations. With bonds on the rise and equities struggling, the “reflation trade”, that was all the rage at the start of the year, appears to be coming to an end. Low growth and low inflation have been endemic ever since the financial crisis more than a decade ago – that the missing ingredient needed to finally turn things around was a global pandemic always seemed a bit unlikely.

The market is sending a clear signal to policy makers. Investors were at their most optimistic when they thought central banks were going to fund a multi-year spending binge without overly worrying about inflation. While there is little appetite for that policy now, hence the correction, the government spending genie might be out of the bottle. In the longer term, temptation to spend freshly printed money might prove too much.

GLOBAL: GOVERNMENT BOND YIELDS TUMBLE AS INFLATION FEARS RECEDE

The biggest move in markets this week has been the sharp fall in government bond yields. An increase in investor demand has accelerated the steady decline in government bond yields seen in recent months. The fall in yields has been most dramatic in UK gilts, but US Treasuries and the bonds of other developed countries have followed the same trend. The effects have also been felt in equity markets as high growth tech stocks have rallied at the expense of value stocks.

The decline in yields has been most noticeable in longer dated bonds, suggesting that markets have gradually accepted that inflation will be transitory and interest rates will remain at very low levels. Data released this week shows that European retail sales fell in the second quarter, while in the UK consumer credit and consumer spending have been falling since April, easing concerns that lockdown would release a huge amount of pent-up consumer demand. The increase in coronavirus infections has also seen expectations of further rapid economic growth reduced.

EUROPE: ECB’S NEW INFLATION TARGET TO ALLOW SHORT-TERM OVERSHOOT

The European Central Bank has modified its official inflation target from ‘near, but below 2 per cent’ to exactly 2 per cent, but with limited tolerance of higher or lower inflation in the short term. This brings the ECB into line with the Bank of England and US Federal Reserve’s official inflation targets and removes the uncertainty of the previous wording. However, it has stopped short of the US Fed’s aim of average inflation. The change follows a review of the ECB’s strategy and objectives, which also sees the bank include the impact of climate change in its decision making and include the cost of housing in its inflation calculations.

The new target is unlikely to cause any changes to monetary policy in the short term. The ECB is current meeting its official target (although only just) but the last 10 years have seen inflation consistently falling short. The more transparent target and removal of bias towards lower inflation gives the bank wider scope to take more dramatic action to boost inflation in the future.

EQUITIES: REGULATORY CONCERNS WEIGH ON SOME TECH STOCKS

Chinese ride-hailing service Didi Chuxing saw its value drop by a third this week after China’s cyber security regulator ordered its app to be taken down due to suspected violation of data rules. Last week the company raised more than $4bn during its New York IPO but the launch of the investigation saw its shares plunge and it led to a broad decline in US-listed Chinese stocks.

Chinese technology stocks have seen increasing regulatory intervention in recent months, with companies listed outside of China and Hong Kong receiving particularly close attention, as China exerts its authority over these giant companies. Chinese tech stocks have recently underperformed, partly due to regulatory interference while some tech companies have retreated from stock market listings as they become more conscious of the regulatory risks involved. Keep, a fitness app backed by Softbank and Tencent, recently cancelled its plans for an IPO and last year saw the IPO of Ant Financial cancelled at the last minute.