BII Fixed Income Strategy May 2017: Reevaluating reflation

Global fixed income markets are flashing caution on the reflation trade, with yields halting their late 2016 climb, curves flattening and market-based inflation expectations waning. Yet we believe these market moves mostly reflect a temporary flight to safety in the face of political uncertainties – rather than a breaking down of the underlying reflationary dynamic. We see this dynamic as alive and well, with the global economy moving from acceleration to a phase of sustained growth.

Highlights

• Credit markets – investment grade, emerging market debt and especially high yield – already appear to reflect reflation in their valuations. We believe this implies future total returns will be more modest than in past years, and will be dominated by carry – or the income component – rather than by further spread tightening.
• Risk-on and risk-off episodes are becoming increasingly global, our research suggests. European yields became a key driver of U.S. Treasury yields in the periods around last year’s UK Brexit vote and the recent French election, we find. A waning of European political risk could lift global yields in coming months.
• U.S. yields are now more properly reflecting Federal Reserve tightening expectations, we believe, against a backdrop of stable growth and normalizing inflation. Long-term yields may modestly rise under the prospect of an eventual removal of extreme monetary accommodation in the eurozone and Japan.

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