Reflation trade faces reset as inflation peak contemplated

NEW YORK – As the vaunted Trump reflation trade continued to wobble this week, politics took most of the blame. For a growing number of strategists, the reason is far simpler — inflation may have peaked.

A dwindling appetite for risk assets has been on display, with the dollar weakening to the lowest level since just after the U.S. presidential election, stocks notching the biggest drop of the year and Treasury yields dropping to the least in four weeks.

“U.S. headline inflation has peaked, euro-zone headline inflation has peaked — even Chinese producer price inflation has peaked,” said Martin Enlund, chief currency strategist at Nordea Markets in Stockholm. “Global markets need new positive shocks in the form of fiscal easing in the U.S. or a surprising uptick in core inflation,” or else the reflation trade will continue to “falter,” he said.

The change in sentiment may be best seen in the inflation-protected bond market. Two-year break-even rates, derived from the spread between yields on nominal and inflation-protected Treasuries, had overtaken those for the 10-year maturity for 12 consecutive trading sessions going into this month, suggesting investors were more concerned about rising consumer prices in the short term. That had happened only six times in the prior five years. Two-year break-even rates have now dropped below those for the longer maturity.

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Break-even rates began to fall after crude oil prices slumped, suggesting investors have thrown in the towel on an imminent acceleration of pricing pressures. Declining oil prices and a persistent production glut threaten to dampen gasoline’s contribution to headline inflation.

“The inflation pulse in advanced economies is close to peaking,” analysts at Australia & New Zealand Bank, led by Tom Kenny, wrote in a note.

“Our estimates show that even if oil prices remain at current levels, energy prices will significantly lower headline inflation across most of the Group-of-Ten nations in the coming months,” foreign-exchange strategists at Nomura Holdings Inc., led by Peter Dragicevich, wrote in a note. They recommend low-yielding currencies such as the yen.

Nordea recommends being underweight commodity-linked currencies, such as the rand, and in markets where core price increases are undershooting inflation targets. Investors positioned for higher yields in Australia may be disappointed too, it adds.

Strategists at Bank of America Corp., meanwhile, reckon the selloff in oil represents an opportunity for debt issued by oilfield service and equipment companies, but warn that U.S. high-yield debt will have a tough time in the event crude continues to slide.

Once of the biggest questions raised is what will the loss of momentum in oil mean for Treasury bulls. The earlier rally in petroleum prompted net non-commercial futures positions to swell to record levels by year-end. However, speculative shorts dumped those positions swiftly in concert with crude’s decline.

To be sure, a pickup in global trade, abundant global liquidity and the prospect of U.S. fiscal stimulus may all add a buffer to the reflation story, absent momentum in the commodity prices. Meanwhile, oil isn’t the only driver for weakening projections for inflation, amid tepid wage growth, and well-anchored consumer inflation expectations.

“In all, the softer tone in key commodity markets raises the likelihood of a financial market ‘reset’ in the near term, along with a pick-up in volatility,” Andrea Cicione, strategist at Lombard Street Research Ltd. said in a client note.