Deflated Hopes

Bond Traders Rethink Reflation

Inflation-protected securities are losing value for the first time this year.

A new sentiment washed over investors immediately after the U.S. presidential election in November.

Traders started to believe in a new narrative of reflation, a marked shift from the many months of talk about deflation and persistent slow economic growth. They piled into inflation-protected securities and bought riskier assets. They projected higher commodity prices because big economies were suddenly about to build more roads, bridges and tunnels.

But that faith has started to evaporate in the past few weeks.

Punctured Hopes

Expectations for inflation in the next decade have declined over the past month

Source: Bloomberg

Investors have been withdrawing cash from U.S. inflation-protected securities, which are losing value for the first time this year. They're starting to demand a little more yield to own junk bonds, a notable shift from the recent exuberance in this market. And they're backing away from smaller company stocks, which were thought to be among the biggest beneficiaries of the post-election enthusiasm.

Shifting Winds

Inflation-protected U.S. securities are poised for their first monthly loss this year

Source: The BofA Merrill Lynch US Inflation-Linked Treasury Index

Data for March 2017 is through March 8

So why the change? First of all, investors are starting to realize that President Donald Trump faces some big hurdles to spending $1 trillion on infrastructure and rolling back regulations, as promised. There are questions about what he'll be able to do and how quickly.

Second, traders are starting to worry that a faster pace of interest-rate increases will materially slow U.S. growth. While the Federal Reserve moved away from its crisis-era stimulus efforts at a glacial pace over the past three years, the central bank is poised to raise rates much more quickly this year in response to higher inflation expectations.

As U.S. Treasury yields rise, longer-term inflation expectations are falling, highlighting the fear that a hawkish Fed will interrupt the U.S. economy's momentum.

And third, oil prices are falling. This matters quite a bit because crude values have closely tracked inflation expectations over the past few years. This isn't an obvious relationship. On one hand, lower oil prices should allow economies to grow faster because consumers who save money at the gas pump can spend more eating out at Olive Garden and buying Gap jeans.

Out of Gas

Energy junk-bond yields are climbing as oil prices fall to the lowest in months

Source: Bloomberg Barclays High Yield Energy index

But traders often use oil as a proxy for understanding the global economy. If big countries are expanding quickly, the thinking goes, they'll need to buy more crude and other commodities. So lower oil prices are sometimes taken as a signal for lower growth ahead.

There's also the more direct effect that falling oil values has on speculative-grade bonds, many of which are tied to riskier drilling companies. Yields on these notes have surged to the highest in three months, leading losses more broadly throughout the $1.3 trillion U.S. high-yield market.

Less Demand

The largest junk-bond ETF just had the biggest outflows since the U.S. election

Source: Bloomberg

While investors may return to the reflation narrative again, it'll take more than a few political speeches to get them there. For now, traders are losing faith in rapid reflation. It's likely they'll continue backing away from the assets that benefited most from this concept until there are concrete developments that push them back to believing again.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at

    To contact the editor responsible for this story:
    Daniel Niemi at

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