FIXED INCOME STRATEGY

Reevaluating reflation

May 15, 2017 / By Jeffrey Rosenberg

Global bond markets are flashing caution on the reflation trade. Yet we see the underlying reflationary dynamic as alive and well, as the economy moves from acceleration to a phase of sustained growth.

Fixed income highlights

  • Credit markets 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.

Snapshot

What are the credit markets telling us about reflation? Credit spreads today look to be roughly where you would expect based on their historical relationship with global PMI levels, our analysis shows. See the chart below. Investment grade and emerging market debt spreads are right in line with the historical trend line since 2006. High yield bond spreads are a little tighter than they should be according to the analysis. This highlights rich valuations, which contribute to our “up-in-quality” preference in credit.

Pricing in reflation
Global PMIs versus credit spreads, 2006-2017

Pricing in reflation

Sources: BlackRock Investment Institute, Bloomberg. May 2017.
Notes: The global manufacturing PMI is a weighted average of readings from China, U.S., Germany, India, Japan and Brazil. U.S. investment-grade, U.S. high-yield and emerging-market hard-currency debt spreads are represented by the Bloomberg Barclays U.S. Corporate Bond, U.S. Corporate High Yield indexes, and the JPMorgan Emerging Market Bond Index. Each dot is a monthly observation. The current level of the credit spreads and global PMIs are as of the end of April 2017. The diagonal lines indicate linear regressions for each sector based on the 2006-2017 period.

Jeffrey Rosenberg
Chief Fixed Income Strategist
Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Fixed Income Strategist with responsibilities in developing BlackRock's strategic and tactical views ...