Treasury market’s bets on 2021 reflation face January reckoning

By Elizabeth Stanton and Edward Bolingbroke

January is shaping up to be a pivotal month in determining whether the nascent US reflation trade can really gather steam in 2021.

Bond traders have boosted expectations for inflation to near the highest in two years as they await an election next week that will determine control of the Senate and potentially the scope for further fiscal stimulus. The full economic fallout from the global coronavirus pandemic remains uncertain, with case numbers surging and vaccinations proceeding more slowly than projected. And the realities of a new U.S. administration will start to become apparent after Democrat Joe Biden takes the oath of office on Jan. 20.

With volatility in U.S. interest rates near historic lows as a result of the Federal Reserve’s rock-bottom policy rate and asset purchases to foster economic recovery, traders are capitalizing on any possible source of price swings — such as the Georgia Senate runoffs on Jan. 5. Over the past week, the eurodollar options market has seen rising demand for structures that would profit from higher Treasury yields and a steeper yield curve — trades that could pay off if Democrats win both races to secure a Senate majority.


But while a reflationary outlook has held sway since early November, when Biden won the U.S. presidential election, there’s ample willingness to take the other side. One popular wager of late in 10-year Treasury note options has been to bet against the yield rising above 1% by taking a short position on February 2021 put strikes that correspond to a yield near that level. And in 30-year bond futures, speculators have reduced their net short positions, suggesting they see limited scope for further yield increases.
“The bias is going to be toward higher yields broadly speaking, but it’s going to be hard to break out of the range in the first few weeks of the year,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale SA. Economic data will provide “a reality check,” but Democratic victories in the Georgia Senate races “could push yields higher given the propensity for more spending coming from the Biden administration,” she said.

The 10-year yield has held firmly between 0.5% and 1% since late March and ended last week at 0.91%.

One key measure to watch will be the inflation expectations implied by bond market pricing. The difference between yields on 10-year inflation-protected debt and ordinary Treasuries — which reflect expectations for average annual growth in the consumer price index over the next decade — reached 1.992% on Monday, the highest since December 2018. Fed policy makers, who in August said they’d seek inflation that averages 2% over time by allowing price pressures to overshoot after periods of weakness, have said stronger inflation expectations are key to that effort.

Also consistent with a reflationary stance is the steepening of the yield curve over the past month. The premium of 10-year yields over 2-year rates approached 85 basis points — a three-year high — while the comparable gap between 5- and 30-year securities topped 133 basis points for the first time since the days following the 2016 U.S. election. Yield levels across the curve remain low by historical standards, however.

More curve steepening is likely in 2021, as is outperformance by Treasury Inflation-Protected Securities, said Bryce Doty, portfolio manager at Sit Fixed Income Advisors.

“Never underestimate the psychological boost of the new year, though it won’t come through in the data for another month or two, if not a full quarter,” he said. “The yield curve remains stable until we see the first upticks in CPI in February and March. TIPS will be a play and the curve will steepen, but you’ll have four-to-six weeks to prepare.” Still, the coronavirus vaccination timeline will be the main determinant of how markets will fare, he said.

A resurgence of economic growth and inflation could end a streak of annual gains for U.S. debt that’s seen the Bloomberg Barclays Treasury Index return a total of around 27% over the past seven years, or around 3.5% a year. Bond index returns are rarely negative, Ira Jersey, chief U.S. interest rate strategist for Bloomberg Intelligence, observed in a report, “but with yields so low, even a modest selloff would push returns below zero.”


Macro highlights of the week ahead include December labor market data and minutes from the Federal Open Market Committee’s Dec. 16 policy meeting.

U.S. economic data calendar:

Jan. 4: Markit purchasing managers index for manufacturing; construction spending

Jan. 5: ISM manufacturing gauge; vehicle sales

Jan. 6: MBA mortgage applications; ADP employment change; Markit PMI for services; factory, durable goods and capital goods orders

Jan. 7: Weekly jobless claims; Challenger job cuts; trade balance; Bloomberg consumer confidence; ISM services index

Jan. 8: monthly jobs report; wholesale inventories and trade sales; consumer credit

Fed calendar:

Jan. 4: Chicago Fed’s Charles Evans, Atlanta Fed’s Raphael Bostic, Cleveland Fed’s Loretta Mester

Jan. 5: Evans, New York Fed’s John Williams

Jan. 6: Minutes of Dec. 16 FOMC meeting

Jan. 7: Philadelphia Fed’s Patrick Harker, St. Louis Fed’s James Bullard, Evans

Jan. 8: Vice Chair Richard Clarida

Auction schedule:

Jan. 4: 13-, 26-week bills

Jan. 5: 42-, 119-day cash management bills

Jan. 7: 4-, 8-week bills

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