The “reflation trade” that has dominated financial markets since the rise of coronavirus vaccines last year has slowed down after the Federal Reserve unexpectedly signaled a shift in its stance on inflation.
Commodity prices have fallen as long-term US Treasury bond prices rocketed after Fed officials this week reacted to unexpectedly strong inflation data by pushing forward their predictions for when it could start raising interest rates. On Friday, the dollar headed into its best week since September last year.
The Fed’s shift marks a major setback for investors this year rushing to buy securities that could benefit from faster inflation, assuming the combination of exceptionally simplistic monetary and fiscal policies and a global economy emerging from the Covid 19 lockdown comes, would bring prices down. peak.
The pivot of central bank officials has raised doubts about how much inflationary pressures the Fed is really willing to tolerate. The central bank also said it would soon begin discussing when to phase out its $120 billion monthly bond purchases.
“If the Fed gets a whiff of inflation and they come in and knock it down again, why should an investor worry that long-term inflation is too high?” said Michael Pond, head of global inflation-related research at Barclays. “The more the Fed is concerned about inflation too high, the less the market should be concerned.”
US stock markets fell on Friday, with the S&P 500 down about 1 percent, despite precious metals recovering slightly from the previous day’s losses and bond yields changing little.
The declines followed comments from St. Louis Fed president James Bullard about the prospects of an even earlier rate hike than current projections suggest. In an interview with The Washington City Times, he predicted a launch in late 2022 in the face of 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 percent over the course of the week. This dragged the British pound 0.8 percent down to $1.38 – its lowest point in nearly 2 months – and brought this week’s losses to 2 percent. Other major currencies also came under pressure, with the euro falling to $1,187.
Krishna Guha, vice chairman of Evercore ISI, said Thursday’s violent moves had come as some investors were forced to liquidate reflation trades as markets turned against them.
Commodities, seen by many investors as a hedge against inflation, took the brunt of sales this week. The Bloomberg Commodity Index is down more than 3 percent so far this week, heading into its worst week since the start of the pandemic.
Copper, which is used in everything from freezer refrigerators to wind turbines, fell about 8 percent in a week to Friday, while wood, which had seen an extraordinary rally as a result of a booming U.S. housing market, fell more than 15 percent.
Commodities were also plagued by a strong US dollar, making dollar-denominated commodities more expensive for holders of other currencies. Metals took a hit from China’s decision to release some of its strategic metals reserves to help control prices.
“The recent strength of the dollar has led to a mechanical sell-off of commodities produced in emerging markets.” . . yet our currency strategists view the impact of the Fed meeting as a passing tailwind,” said Jeff Currie, chief of commodities research at Goldman Sachs. “They continue to forecast broad weakness in the US dollar, driven by the currency’s high valuation and a broader global economic recovery.”
So-called U.S. value stocks — often cheaper, out-of-favour companies that are more sensitive to the pace of economic growth — fell a further 1.3 percent on Thursday after the initial decline they continued on Wednesday, the day of the Fed’s announcement. to extend . The MSCI index of global value stocks was already down 1.2 percent on Thursday.
The Russell 2000 index of smaller US companies fell more than 1 percent on Friday — the biggest reversal in more than a month — while the price of a troy ounce of gold fell to a two-month low of $1,773 on Thursday, before falling. rose slightly on Friday.
However, other assets have benefited. The diminishing likelihood of the Federal Reserve letting inflation spiral out of control has led to a rally in long-term US Treasuries and other securities that benefit from disinflationary pressures, such as high-rated corporate bonds and many major technology stocks.
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The yield on 30-year US Treasuries fell to its lowest level since February, standing at 2.03 percent on Friday, from 2.21 percent ahead of the Fed meeting. Yields fall as prices rise. Two-year treasuries, which have barely contracted this year and are more sensitive to changes in monetary policy, rose to 0.27 percent, from 0.16 percent at the start of the week.
The sharp adjustment forced the strategists at Morgan Stanley and TD Securities to announce that they had ended so-called “steepener” trades that benefit when longer-dated Treasuries sell 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 borrowing costs in the US.
The magnitude of the shift in the world’s largest bond market is a sign that some investors are beginning to question the Fed’s commitment to its new, more flexible inflation targeting regime, Guha said. Since last year, the US central bank has said it will raise inflation above the 2 percent target to balance periods of low inflation.
However, since Wednesday’s Fed meeting, inflation expectations have extended their recent declines. The 10-year U.S. break-even, a closely monitored gauge of expectations for the next decade, stood at 2.23 percent on Friday, down 2.39 percent.
Despite the post-Fed moves, some investors remain confident in reflation trading. Mark Dowding, chief investment officer of BlueBay Asset Management, said the Fed’s plans to phase out its asset purchases would eventually weigh on bond prices and boost yields, adding that the central bank had simply responded. on stronger-than-expected inflation data in the past two months rather than making a fundamental change in its policy.
“The average approach to inflation targeting remains intact, as does strong economic growth,” he said. “This was frustrating, but it was one of those moments as an investor when we have to stick to our guns.”