Reflation trades take a hit as Fed change resets markets

The “reflation trade” that has dominated financial markets since the emergence of coronavirus vaccines last year was pummeled after the Federal Reserve unexpectedly signaled a shift in stance on inflation.

Commodity prices fell as long-term U.S. government bond prices rose after Fed officials reacted to surprisingly strong inflation data this week by pushing forward their forecast for when it might. start raising interest rates. The dollar was heading for its best week since last September on Friday.

The Fed’s change marks a major setback for investors who have rushed this year to buy securities that could benefit from faster inflation, betting that the combination of exceptionally easy monetary and fiscal policy and an economy global emerging from its Covid-19 lockdown would spike prices down.

The pivot of central bank officials has raised doubts about the inflationary pressures the Fed is really prepared to tolerate. The central bank has also signaled that it will soon start discussing when it will reduce its bond purchases by $ 120 billion per month.

“If every time the Fed has a puff of inflation and comes and slaps it, why would an investor worry that long-term inflation is too high?” said Michael Pond, head of global inflation research at Barclays. “The more the Fed worries about too high inflation, the less the market should worry.”

US equity markets fell on Friday as the S&P 500 fell about 1%, despite precious metals rebounding slightly from yesterday’s losses and bond yields little changed.

The declines followed comments by James Bullard, chairman of the St. Louis Fed, on the prospects for an interest rate hike even earlier than current projections suggest. In an interview with CNBC, he predicted a takeoff in late 2022 amid higher than expected inflation.

The US dollar rose further on Friday, with the dollar index measuring the dollar against major currencies gaining about 1.9% during the week. That took the pound down 0.8% to $ 1.38 – its lowest point in almost 2 months – and took this week’s losses to 2%. Other major currencies were also put to the test, with the euro falling to $ 1.187.

Krishna Guha, vice president of Evercore ISI, said Thursday’s violent moves came as some investors were forced to wind up reflation trades when markets moved against them.

Commodities, viewed by many investors as a hedge against inflation, were the top sellers this week. The Bloomberg Commodity Index has fallen more than 3% so far this week, heading into its worst week since the start of the pandemic.

Copper, used in everything from fridge-freezers to wind turbines, fell about 8% in one week to Friday, while lumber, which saw an extraordinary rebound thanks to a declining US real estate market. booming, fell more than 15%.

Commodities have also been weighed down by a strong US dollar, making commodities denominated in greenbacks more expensive for holders of other currencies. Metals have been hit by China’s decision to release some of its strategic metal reserves to help dampen prices.

“The recent strength of the dollar has led to a mechanical liquidation of commodities produced by emerging markets. . . yet our currency strategists see the impact of the Fed meeting as a transient tailwind, ”said Jeff Currie, head of commodities research at Goldman Sachs. “They continue to forecast general weakness in the US dollar, driven by the currency’s high valuation and an expanding global economic recovery.”

So-called US value stocks – often cheaper, less appreciated companies that are more sensitive to the pace of economic growth – fell another 1.3% on Thursday to extend the initial decline they suffered on Wednesday, the day of the Fed’s announcement. . The MSCI Global Value Equity Index had already fallen 1.2 percent on Thursday.

The Russell 2000 Index of U.S. Small Businesses fell more than 1% on Friday – the biggest reversal in more than a month – as the price of a troy ounce of gold slipped to its lowest level on Thursday in two months to $ 1,773, before rising slightly. Friday.

Other assets have benefited, however. The diminished chances that the Federal Reserve will let inflation get out of hand has helped trigger a rally in long-term U.S. Treasuries and other securities that benefit from disinflationary pressures, such as well-rated corporate bonds and bonds. many big tech stocks.

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The yield on 30-year US Treasuries plunged to its lowest level since February and stood at 2.03% on Friday, down from 2.21% before the Fed meeting. Yields fall when prices rise. Two-year Treasuries, which had barely budged this year and are more sensitive to changes in monetary policy, jumped to 0.27% from 0.16% earlier in the week.

The sharp adjustment forced strategists at Morgan Stanley and TD Securities to announce that they had ended the so-called “steeper and steeper” deals that benefit when longer-term Treasuries sell at a slower pace. faster than their short-term counterparts.

This reflation trade had gained prominence since late last year as investors positioned themselves for higher inflation and higher US borrowing costs.

The scale of the shift in the world’s largest bond market is a sign that some investors are starting to question the Fed’s commitment to its new, more flexible inflation-targeting regime, according to Guha. Since last year, the US central bank has said it will let inflation exceed its 2% target to compensate for periods of low inflation.

Since Wednesday’s Fed meeting, however, market inflation expectations have prolonged their recent declines. The US 10-year breakeven point, an indicator of expectations closely monitored over the next decade, traded at 2.23% on Friday, from 2.39%.

Despite the post-Fed moves, some investors remain confident in the reflation trade. Mark Dowding, chief investment officer of BlueBay Asset Management, said the Fed’s plans to reduce its asset purchases would eventually weigh on bond prices and force yields to rise, adding that the central bank simply reacted to inflation data stronger than expected in the past. two months rather than making a fundamental change in its policy.

“The approach to targeting average inflation remains intact, as does strong economic growth,” he said. “It’s been frustrating, but it’s been one of those times as an investor where we have to stick to our guns.”

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