The “reflation trade” that has dominated financial markets since the emergence of coronavirus vaccines last year has been pummelled after the Federal Reserve unexpectedly signalled a shift in its stance on inflation.
Commodity prices have tumbled while long-dated US government bond prices raced higher after Fed officials this week reacted to unexpectedly strong inflation data by moving forward their forecasts for when it might start raising interest rates. The dollar was headed for its best week since last September on Friday.
The Fed’s shift marks a major setback for investors who this year have rushed to buy securities that might benefit from faster inflation, betting that the combination of exceptionally easy monetary and fiscal policy and a global economy emerging from its Covid-19 lockdown would cause prices to spike.
The pivot from central bank officials has raised doubts about how much inflationary pressure the Fed is really willing to tolerate. The central bank also signalled that it would soon start discussing when it would taper its $120bn-a-month bond purchases.
“If any time the Fed gets a whiff of inflation and they come in and slap it back down, why would any investor worry about long-term inflation being too high?” said Michael Pond, head of global inflation-linked research at Barclays. “The more the Fed is concerned about too high inflation, the less the market should be concerned.”
US stock markets dropped on Friday morning, with the S&P 500 lower by 1 per cent, despite precious metals rebounding slightly from the previous day’s losses and bond yields little changed.
The declines followed comments from James Bullard, president of the St Louis Fed, about the prospects of an even earlier interest rate increase than current projections suggest. In an interview with CNBC he forecast liftoff in late-2022 in the face of higher than anticipated inflation.
The US dollar rose further on Friday, with the dollar index measuring the buck against major currencies gaining roughly 1.9 per cent over the week.
Krishna Guha, vice-chair of Evercore ISI, said Thursday’s violent moves had come as some investors were forced to liquidate reflation trades when markets moved against them.
Raw materials, seen by many investors as a hedge against inflation, took the brunt of the selling this week. The Bloomberg Commodity index has fallen more than 4.5 per cent so far this week, heading for its worst week since the start of the pandemic.
Copper, used in everything from fridge freezers to wind turbines, was down roughly 8 per cent on the week while lumber, which has enjoyed an extraordinary rally on the back of a booming US house market, dropped nearly 15 per cent.
Commodities were also weighed down by a strong US dollar, which makes greenback-denominated raw materials more expensive for holders of currencies. Metals took a hit from China’s decision to release some of its strategic reserves of metals to help…
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