The world’s governments have crossed “the Rubicon of fiscal rectitude to a reach a new land”, says Albert Edwards of Société Générale – “one where their existing monetary profligacy can now be coupled with fiscal debauchery”. There is no “turning back now the sweet fruits of monetary-funded fiscal largesse have been plucked and tasted”. So why are bond yields – the borrowing costs of those governments – falling again?
Reflation trade in reverse
Investors have spent much of this year piling into assets that stand to gain from a broad global recovery. Reopening plus continued fiscal and monetary stimulus is especially good for cyclical shares such as banks, industrial companies and commodity producers. Big technology shares, which did very well in 2020, have underperformed.
But this “reflation trade” is coming under pressure. Soaring US inflation had caused bond yields to rise – expectations of higher future inflation and interest rates cause investors to demand a higher yield as compensation. The yield on the benchmark ten-year US Treasury bond rose from below 1% at the start of the year to nearly 1.75% in March. But it has since retreated, briefly falling below 1.3% last week. That suggests markets see weaker growth ahead.
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The same pattern can be seen in stocks, says William Watts for MarketWatch. The small-cap Russell 2000 index, which contains many cyclical businesses, has fallen for two weeks straight even as the tech-dominated Nasdaq 100 has climbed. Tech stocks proved their resilience in the face of the economic turmoil last year, making them a preferred pick if the economy is slowing.
A mere growth scare
“Fears of runaway inflation” have dominated markets for much of this year, says Watts. But the focus is now on “worries about a rapid slowdown in global economic growth”. The fastest phase of the US recovery is over, while a slowdown in Asia could prove a drag on global growth (see below). Investors are also concerned that the Delta variant will wreak new economic havoc. As “the old aphorism” has it, markets “do not react, they overreact”, says the Financial Times. Bond markets arguably overdid the inflation panic earlier this year. Slightly more hawkish language from the US Federal Reserve has since calmed those nerves. Instead, investors have started overreacting to the slightest hint of slower growth.
Politicians’ ongoing fiscal splurge means that reflation will come eventually, says Edwards. “The problem is the markets have been too early in betting on the reflation trade and are now set up for a huge disappointment.” Not so fast, says Ambrose Evans-Pritchard in The Daily Telegraph. Annual US inflation hit 5.4% last month, the highest reading since August 2008 (see page 10). A $3trn US budget deficit and “a 32% rise in the total M2 money supply” since the pandemic began means we are heading for durably higher inflation. That could force central bankers to “hit the brakes sooner and harder” than expected. Fasten your seatbelt.
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