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 from central bank officials has raised doubts about inflationary pressures that 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 morning as the S&P 500 fell 1%, despite a slight rebound in precious metals from yesterday’s losses and little changed bond yields.
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.
Krishna Guha, vice chairman 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 4.5% 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% on the week, while lumber, which has seen an extraordinary rebound thanks to a booming US real estate market, has fell almost 15%.
Commodities have also been weighed down by a strong US dollar, making commodities denominated in greenbacks more expensive for currency holders. 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 caused a massive sell-off 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 american value stocks – often cheaper and disadvantaged companies that are more sensitive to the pace of economic growth – fell another 1.3% Thursday to extend the initial decline they suffered on Wednesday, the day the Fed announced. The MSCI Global Value Equity Index had already fallen 1.2 percent on Thursday.
The Russell 2000 Index of U.S. Small Businesses fell 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 in two months on Thursday to $ 1,773, before rising slightly on Friday.
Other assets have benefited, however. The diminished chances of the Federal Reserve letting 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 highly rated corporate bonds, the US dollar and many big tech stocks.
The yield on 30-year US Treasuries plunged to its lowest level since February and stood at 2.06% on Friday, down from 2.21% before the Fed meeting. Yields fall when prices rise.
The scale of the shift in the world’s largest bond market is a sign that 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 10-year US breakeven point, a measure closely followed by expectations over the next decade, traded at 2.25% 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 end up weighing down bond prices and forcing 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.”