April 19, 2017 / 12:18 PM / 2 years ago

Reflation trades of 2016 deflate with remarkable speed

LONDON (Reuters) - Stocks, bond yields and the dollar are all falling, yield curves are flattening and sterling is marching higher. The “reflation” trades of 2016 that were supposed to mark a turning point in global markets are fading.


The question for investors is whether this is the play book for the rest of the year, or whether the trends of 2016 will resume in the second half of the year.

What is clear is that much of the conviction with which investors went into 2017 has been lost. This week, Goldman Sachs ditched its long-standing bullish call on the U.S. dollar, and Deutsche Bank did likewise with their gloomy sterling outlook.

Following the developed world’s two most seismic events last year — the U.S. presidential election and Britain’s vote to leave the European Union — investors around the world had positioned for a broad-based reflation trade.

Trump’s surprise election victory was supposed to unleash a wave of tax cuts, banking deregulation and fiscal largesse that would lift U.S. — and global — growth.

Meanwhile, sterling’s 20 percent plunge after the Brexit vote was supposed to pave the way for a surge in UK equities and inflation.

This, indeed, is how it played out as 2017 got underway. The Federal Reserve raised interest rates twice, the dollar reached a 14-year peak, Wall Street hit record highs, and government bond yield curves around the world steepened to the benefit of banks and financial stocks.

But it is now unraveling, in large part due to a clear slowdown in U.S. growth and signs that global inflation is leveling off.

Flatter yield curves where short- and long-term bond yields are close to each other suggest economic uncertainty.

“(They) are definitely not corroborating a Trump reflation scenario. Some of the survey data is strong and has hit new multi-year highs, but the real data has been tepid,” said Jonathan Tepper, co-founder of Variant Perception Research.

Citi’s economic surprises indexes for most of the world’s major economies have been heading south for the past month. The U.S. index has suddenly tumbled to lows not seen since November, and is below all its peers apart from Japan’s.

And inflation expectations are showing signs of peaking too.

The dollar is now down 2.5 percent year-to-date (but still up 2 percent since the U.S. election; U.S. bank stocks are down 10 percent from their February peak (but still up 20 percent from the election); and sterling is down 13 percent against the dollar since the Brexit vote last June (but it has been down as much as 20 percent).


Estimates of first quarter U.S. growth have been slashed in recent weeks, with the Atlanta Fed’s closely-watched GDPNow model pointing to just 0.5 percent compared with around 2.5 percent less than two months ago.

U.S. Treasury Secretary Steven Mnuchin said the Trump administration’s timetable for tax reform is set to falter following setbacks in negotiations with Congress over healthcare.

More than 40 percent of the fund managers surveyed by Bank of America Merrill Lynch do not expect U.S. tax reforms to be passed before 2018.

The same survey also showed that major adjustments are taking place in key markets, and that some measures of positioning are reaching extreme levels.

Investors’ exposure to U.S. equities is its lowest since January 2008, but their allocation to global banks is the highest on record.

“Investors are scrambling out of U.S. equities as the majority find U.S. stocks overvalued and perceive a risk of delayed U.S. tax reform,” said Michael Hartnett, chief investment strategist at BAML.

Among the biggest fallers on Wall Street have been banks. They rose more than 30 percent in the three months after the U.S. election but have since drifted lower and are now down on the year.

The extreme overweight bank positioning highlighted in the BAML survey suggests there’s more room to fall. A flatter yield curve is bad news for banks, who make much of their money by borrowing cheaply at the short end and lending longer term at higher rates of interest.

The difference between 10-year and two-year U.S. yields touched 100 basis points on Tuesday, the lowest since November and a far cry from 135 bps in December. And that’s despite the 50 bps rise in U.S. interest rates since December.

“Banks don’t tend to do well in a flattening yield curve environment,” said Tepper at of Variant Perception Research, whose website states: “The yield curve is by far the best predictor of economic growth in most economies of the world.”

The dollar doesn’t do well in this environment either. On Tuesday Goldman Sachs abandoned its bullish call.

Also on Tuesday, Deutsche Bank did the same with its bearish sterling forecast after British Prime Minister Theresa May’s surprise announcement to call a UK general election - a “game-changer” for the pound, they said.

Editing by Jeremy Gaunt.

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