Markets reconsider the reflation trade

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Call it the end of the reopening euphoria. Affluent workers who rushed out, as soon as they were allowed, to fancy restaurants and cocktail bars quickly began to realise they had not saved quite so much by working from home as they thought. Similarly, markets have begun to re-evaluate how much difference the pandemic has actually made to the prospects for sustained growth in the global economy. The fears of rapidly rising inflation that dominated markets just a few weeks ago have been replaced by nervousness about growth.

Investors have this week reconsidered the so-called reflation trade: the idea that a robust economic recovery, underpinned by continuing easy money from the Federal Reserve and bumper fiscal stimulus, would boost inflation and inevitably force the Fed to raise rates faster than it had signalled. A combination of production bottlenecks — the ongoing chip shortage is holding back car manufacturing — and the spread of the more infectious Delta variant has now reduced the optimism over economic growth. Long term US Treasury yields — a reflection of inflation and growth expectations — have fallen as the bonds have sold off.

Much of the world is now looking askance at the UK, where one of the world’s most successful vaccination programmes has not been sufficient to stop the Delta strain from proliferating. While Britain’s government is resolutely committed to reopening, consumers and workers are likely to start voluntarily social distancing and staying away from crowded places — reducing the uplift to growth from reopening. On Thursday, Mary Daly, the president of the San Francisco branch of the Fed, said in an interview with the Financial Times that prematurely declaring victory on coronavirus is one of the greatest threats to global growth.

Nevertheless, the market moves did not suggest that investors were keen to shed risk from their portfolios. While some of the frothier parts of the market have lost their fizz — bitcoin and the so-called “meme stocks” have not recovered after price falls — other more conventional risky assets such as tech stocks and junk bonds have rallied as long term interest rates have fallen. Rather than becoming more fearful, investors have re-evaluated the prospects for future monetary tightening. Markets, which were previously more concerned about inflation, are now converging with the central bankers who said it was likely to be “transitory”.

This week’s market action is also a slightly delayed response to the more hawkish tone the Fed struck at its most recent rate-setting meeting last month. The forecasts of policymakers at the central bank that rates would go up sooner than they had said before have no doubt reassured some investors that the central bank will keep inflation under control, and not end up having to respond belatedly with much sharper rate rises further in the future.

Overall, though, the moves may just reflect the old aphorism that markets “do not react, they overreact”. The initial response in bond markets to just a few months of higher than expected inflation was arguably overdone. The latest US wages figures pointed to month-on-month growth of only 0.3 per cent — in line with the anaemic pre-coronavirus norm. Interpreting economic statistics is difficult at the best of times; the volatility and uncertainty created by the pandemic makes it harder than ever.

Nervousness about growth and the latest sell-off of long term treasuries could similarly prove an overreaction that is corrected once again as more data about the strength of the recovery from the pandemic starts to come in.

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