Reflation and the reflation trade are becoming the most used terms to explain in a few words the increase in interest on sovereign debt and the erratic behavior of the stock markets. In reality, they hide a fear of inflation and an overheating of the economy, motivated by an unprecedented deployment of fiscal and monetary aid.
We must go back to the studies on the effects of the measures deployed against the Great Depression to find the first reference to reflation. It was the economist Irving Fisher who coined the term in his work in 1934 and developed the Theory of Reflation. His approach described how expectations of economic growth were accompanied by inflationary pressures due to excessive fiscal or monetary aid.
Meanwhile, the reflation trade is nothing more than the market’s response to this scenario. The increases in equities, especially in cyclical actions, in raw materials and in bond yields, is the way that market agents have to adapt with the return of inflation. Benchmark 10-year Treasury yields have risen nearly 20 basis points in just over a week, hitting a 12-month high.
The problem is that high Wall Street valuations, going from record high to record high since the middle of last year, have changed the perception of a quick recovery to a risk of overheating. The trigger was the next stimulus package in the US, after Biden’s victory. At the end of the month, if nothing goes wrong, there will be others. This extreme has provoked a bitter debate, with some authoritative voices such as Larry Summers (former US Secretary of the Treasury) or Olivier Blanchard, former chief economist of the IMF, warning of the risks and Janet Yellen, current Secretary of the Treasury, defending the .
And all this, with a Federal Reserve assuring that it will not modify its monetary policy until employment has recovered. Nervousness is setting in in the US. Bond interest rates are growing and the yield curve is tilting with long-term growth, while price data is beginning to show signs of life and in the background a market at all-time highs is suffering from vertigo.
“We are all aware that headline inflation is picking up and even the monthly data has picked up a bit, but no one really expects inflation to pick up and stay at levels that will require action from the Fed,” explains Robert Carnall, analyst at ING. Uncontrolled prices would force a rate hike, which could generate great tensions in the market. The current chairman of the Fed, Jerome Powell, has already been through the experience of having to raise the price of money. He did it without a pandemic and without a crisis behind it, and strong corrections in the stock markets were not avoided.
High inflation would be reflected in a rise in real interest rates, dragging up the yield on debt in the markets. “I really think fixed income yields would need to be much higher to derail the bull market in equities. If there is no growth in earnings and yields are higher, that would be a negative for equities given would be affected by the higher discount rate But there is growth and fourth quarter results have brought positive surprises to the upside Year-over-year earnings growth has turned positive Treasury yields could rise higher but I doubt we are about to see a multi-year bond bear market,” says AXA IM’s Chris Iggo.
All the levers of the market are already moving in this direction, although the experts call for calm. The Fed’s interest rate swap markets, which discount the Fed’s movements, have advanced forecasts for interest rate hikes in mid-2023, compared to early 2024, which had been predicted.
The uncontrolled growth of interest means that in the medium term there will be problems in maintaining the recovery in a sustainable way and complicating the current situation of the credit market. More interest means higher financing costs for companies and families. Although in the US the beginning of the year has been strong for GDP, in Europe the increase comes when a double recession is closer than the beginning of the recovery. Everyone trusts in the efficacy of the vaccines and in the aid to keep their heads afloat in the second part of the year. “The reflation scenario is likely to continue,” says Susan Joho, an economist at Julius Baer, acknowledging that “the market is probably too anxious about the growth impact of Biden’s stimulus plans.”
The combination of recovery expectations and fears of the US economy overheating is causing investors to take more risk by moving away from debt and into cyclical stocks. “Reflationists might say that we are in a very low inflation environment, with huge fiscal and monetary support and high levels of consumer savings accumulated during the lockdown, but that is too optimistic a view,” says Ariel. Bezalel, head of fixed income strategy at Jupiter. And he adds: “the recovery will be slower than some want to believe.”
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