What Is The Reflation Trade?

Reflation is the expectation of a country's economic output to increase due to fiscal & monetary policy stimulus.
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We have a quick question here from Sergio asking, “What exactly is meant by reflation trade?”

Firstly, thanks for the question Sergio So, the reflation trade, in its most basic form is the market hoping that economic growth and inflation will start to rise.

So, when a country is going through a rough patch, let’s say a recession usually have the Central Bank step in to help the economy through the various monetary policy actions such as lowering the interest rates, and in the more unconventional measures like after the global financial crisis, also adopting things like quantitative easing.

Now, there is only so much that a Central Bank can do. They can bump the economy full of money and make that money as cheap as possible by keeping short term interest rates low and obviously by buying longer dated securities like bonds to synthetically keep the longer rates low as well. How much will that help the economy?

The question is, how much will it help in a really bad recession with millions of people losing their jobs? So then all the bond buying in the world will help to some extent, but, you need the economy to actually spend money to make money, right?

So, that is why you’ll often hear economists say that “A Central Bank can print money, “but they can’t print jobs.” And a jump in example, a credit availability might help a company in the short term, but if there is no cash flow, all the credit can only do so much to help them. So, what else can be done? Well, of course, fiscal policy, so that is where the government needs to step in.

Now, there’s many avenues that the government can look at, and to help out the economy in terms of fiscal policy that can be anything from corporate to private tax cuts, and payroll tax cut, stimulus checks, like we’ve seen recently. And then of course, the big one is actually spending money in the real economy through things like infrastructure, spending, etcetera. Now, as the market is forward looking in nature, we won’t… look at what is happening today, right? But the market is always trying to front run what might happen in the future. And when you have massive injections of both stimulus from the monetary and the fiscal side of the economy that usually breeds hopes of reflation.

So, reflation is when the output of the economy or the growth of the economy is boosted and expanded with the help of Central Bank and government stimulus. So, if the market thinks that the growth is going to pick up steadily due to all of that stimulus that should lead to hopes of rising inflation. And when inflation expectations start to rise, you usually see investors rotate out of things like bonds and into equities. Especially out… rotating out of longer dated maturities at the back end of the curve, like a US 10 year treasury bonds as an example.

Remember, the further you go up in maturities, the higher of an impact inflation will have the cost of money. So, this was clearly visible last week when we had the bond yields across various maturities move up in line of that reflation trade. Let’s quickly get the others up as well two, five and three years. We saw all of them move up across the curve, but, we saw a much bigger move in terms of the 10 year. Which is of course much more sensitive to changes in inflation.

Now, at the same time, when you see bond prices fall and yields move up. The reason for that, is investors rotating out of bonds and then you’ll start to see inflows into your more cyclical things like equities. Now, in this type of environment, where both growth and inflation are said to boom. That is usually not a very good thing for the US dollar. But more so from a global perspective than just the US perspective.

So, for example, if the US is experiencing massive growth and inflation rising due to stimulus, but the rest of the world isn’t that still going to be $1 positive. But when the global economy is experiencing rising growth and inflation, that is bad news for the dollar. And that is usually what is referred to as the reflation trade. Now, the thing to keep in mind is that markets can also sometimes be wrong, right? So, with all the government borrowing and spending and Central Bank stimulus, you normally should see inflation. I say normally because it doesn’t always end up with inflation rising. But what happens if you do get inflation rising from all of that spending and borrowing and stimulus, but you don’t get the growth alongside that?

Now, that is called stagflation. And that is a really, really bad place for the economy. So, that is where you have a much higher unemployment rate, growth is super low and suppressed, and now all of a sudden prices starting to rise. So imagine that you’re already, you know struggling because you don’t have a job and now suddenly everything is costing even more than it normally does.

So that’s a really bad place for the real economy, and that’s also something that can occur when we see that rising inflation but not the growth as well. So, I hope that just clarifies what we mean with the reflation trade. Any other questions, just let us know.

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