Air comes out of the reflation trade

Among those whose hopes were dashed by the weaker than expected performance of the Democrats in the US election this week: investors who had bet on a speedy and significant return of inflation.

The reflation trade appeared to have been effectively extinguished by signs that the US Senate is likely to remain in Republican hands, even if Joe Biden is named the winner of the White House. That would be a recipe for legislative gridlock, limiting the prospect of sweeping government spending and capping the economic stimulus Congress might provide.

That at least was the thinking as money managers dialled back their bets on US growth and inflation as election results rolled in, propelling a sharp rally in Treasuries and pushing US break-even rates — a market proxy for inflation expectations — to a one-month low. The 10-year break-even rate, derived from prices of inflation-protected government securities, fell 0.09 percentage points to 1.65 per cent.

“Markets have realised that the reflationary trade is now dead,” said Seth Carpenter, chief US economist at UBS. With a divided Congress, plans for “any sort of big fiscal, reflationary, transformational proposal is gone”.

After months of wrangling between Democrats in the House of Representatives, Senate Republicans and President Donald Trump’s White House, the outgoing Congress had failed to find common ground on a new round of stimulus, but investors bet the election would break the deadlock.

Markets had begun to price in a stimulus package in excess of $2tn early next year plus more still from funds earmarked by Mr Biden for longer-term infrastructure and clean energy initiatives.

Facing the prospect of a divided Congress, strategists now reckon Republican policymakers would push back against any package in excess of $1tn, instead aiming for aid in the ballpark of $500bn.

Scott Minerd, the global chief investment officer of Guggenheim Partners, said that could make for a weaker and more uneven economic recovery.

“I’m a big subscriber to the ‘K-shaped’ theory of recovery,” he said, in which some segments of economy fare significantly better than others. “The market will question how much stimulus will come and how fast it will come and that it is not going to be there to prop up the economy as the [coronavirus] caseload continues to rise.”

Line chart of 10-year US Treasury yields, % showing Investors call time on global reflation trade

The unwinding of the reflation trade was in evidence across sectors and asset classes on Wednesday.

Investors piled into US Treasuries, causing the biggest one-day decline in the 10-year Treasury yield since April.

Gold edged lower, falling $15 to $1,894 a troy ounce at one point before recouping some of its losses. The precious metal is often seen as a hedge against rising inflation, given it tends to rise in value when the purchasing power of the dollar declines.

In the stock market, companies that are dependent on a faster economic recovery, including those in the construction and materials industries, trailed. Technology stocks surged, as investors noted these high-flying companies tend to grow fast regardless of the state of the economy. Lower interest rates are also seen helping to prop up tech valuations, which may seem high versus historical averages but not so much when comparing their earnings to the yield on bonds.

Line chart of Performance of indices on November 4 2020 (%) showing As the reflation trade is scuppered, tech shares outperform

If the reflation thesis no longer applies, it could also have significant implications for the corporate bond markets. Investors warned lower growth and inflation could mean more companies struggle to get out from under their hefty debt loads, leading to a greater number of bankruptcies than currently expected. 

Credit markets have so far proven resilient. Analysts said a gridlocked Congress had removed other tail risks, such as the higher corporate taxes Mr Biden had promised to impose and greater regulation that may have come if Democrats controlled both branches of government.

But traders cautioned that trading volumes were light on Wednesday and there was some unwinding of hedges that investors had put on to protect themselves from a sudden downturn in credit markets, which helped to buoy the price of corporate bonds and loans. Anxious fund managers were largely sitting on the sidelines waiting for further clarity over the election result, traders said. 

Some also expressed concerns about the Federal Reserve and its ability to shore up growth without Congress’s help. Having already slashed rates to zero and waded into a number of critical debt markets, the US central bank may be running out of tools, strategists warn.

“[The Fed] doesn’t actually have many attractive options left,” said Mr Carpenter. “It’s the reason they and central bankers around the world have been clamouring for fiscal policy.”

Some investors took a decidedly more optimistic view. The reflation trade is not “dead”, they argued, just on pause. Sonal Desai, chief investment officer at Franklin Templeton Fixed Income Group, said that not only would policymakers ultimately deliver additional spending, especially if there is a sharp deterioration in the economic data, the moderating effect of a Republican Senate on the Democratic policy agenda could serve as a boon for growth as well.

“Over the next couple of years, you are unlikely to see the tax increases which were anticipated and that, from a growth perspective, is positive,” she said.

Ms Desai conceded the reflation trade is “definitely delayed”, however, and with record numbers of Covid-19 cases and the threats of legal challenges to the presidential election results, others predicted more volatility to come that could postpone it further.

“The reflation trade was a popular trade, and what happens to popular trades during periods of uncertainty? They get challenged,” said Michael DePass, global head of Treasury trading at Citadel Securities. “That is exactly what is happening here.”

Additional reporting by Eric Platt and Richard Henderson in New York

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