The Reflation Trade Is Alive And Well, But Will It Get Into Stagflation?

| About: SPDR S&P (SPY)

Summary

Long-term inflation expectations break to the upside, while the Trumpflation trade fades out.

Is the bond market right in expecting more overheating conditions?

This week’s global macro releases will shed light on this market conundrum, possibly verifying the reflation scenario.

While more and more evidence in favor of the reflationary scenario comes in, many prominent investors, like George Soros, stubbornly call for an imminent full blown financial disaster. Why these prominent voices haven't managed to prove their premises yet? For one and only reason; because they have probably overlooked the short-term business cycle, which up to now has been surprisingly healthy. This cycle, though, will be put under the microscope this week through a series of manufacturing and services PMIs, sentiment indices, and trade statistics scheduled to be released across the globe. Should these critical macro releases confirm the optimism reflected in long-term expected inflation, as currently priced in by the US fixed income market, then a very strong message will emerge; the reflationary trade is gaining traction and stagflation moves further away. However, if these macro data disappoint, then the first cracks in the growth dynamics of the global economy will arise in the form of stagflation risks, with activity indicators falling at a time of inflationary pressures. In other words, either the US fixed income market correctly feels confident about the future state of the economy or the recent weakening of the US dollar (NYSEARCA:UUP) and cyclical shares is the one which tells the real story about where the economy is headed. Soon enough investors will get some pretty solid answers on this debate, potentially providing a solution to this paradox.

Is Breakeven Inflation Too Optimistic?

Despite the fading out of the Trumpflation rally in risk assets and long-term bond yields (NYSEARCA:TLT), there are some market segments which think otherwise; the 10-year breakeven inflation rate, a gauge of bond investor's expectations about inflation over the next decade, broke to the upside through the 2% level, reaching a new two-and-a-half year high. Breakeven inflation is calculated based on the real yields of Treasury Inflation Protected Securities (NYSEARCA:TIP), a market which is mostly traded by professional investors, and this renders this particular indicator higher credence. Why is this move in breakeven inflation important? Because it created a new divergence between inflation expectations and risk assets; and this divergence needs to be ultimately bridged.

As a matter of fact, the Trumpflation trade can be segmented in two distinct phases. In the first phase, from the US Election Day to the end of the year, all cyclical risk assets and the greenback rallied strongly in parallel with inflationary expectations. In the following phase, during the last three weeks, the cyclical sectors and the US dollar lost steam. However, the inflationary expectations kept surging. This created a sizable divergence between the acute optimism reflected in inflation expectations and the adjustment of risk asset prices pointing to the opposite direction, like for example the underperformance of financial shares (NYSEARCA:XLF).

Trumpflation Trade

Source: tradingview.com, St. Louis Fed, US Department of The Treasury

However, this divergence should not come as a surprise. The on-going uptrend in the 10-year breakeven inflation is, in fact, in line with the targets set by earlier technical patterns. Between early autumn of 2015 and last November a sizable head and shoulders bottoming out pattern was formed. The neckline of this technical pattern was ultimately broken to the upside during the US election, triggering a strong upward trend with an upside target of 2.3%. It is the evolution of this particular uptrend that we are witnessing in inflation expectations, currently. Of course, this reflationary signal was accommodated by numerous macro surprises across the globe, spanning from China's unexpected resilience to Germany's and the UK's surprising reflationary and manufacturing strength. In this light it will be of utmost importance to see if the current direction of the global business cycle can gain more steam, fueling a resurgence of the bullish trend in US equities (NYSEARCA:SPY).

BE Inflation

Source: US Department of The Treasury, St. Louis Fed

What The Global Economy Has To Say

The US economy has certainly proved so far that it can act as a locomotive of growth, at least among the other developed economies. This allows the Fed to advance its rate normalization efforts, albeit by walking on a tight rope. There are segments of the economy which have benefited enormously from the ultra-low cost of borrowing, and will potentially face challenges. One such segment is the housing sector. The on-going increase in USD Libor rates, as a reflection of the new tightening cycle, is a potential threat for this interest rate sensitive sector. In this light, the release of the December Existing as well as new home sales in the US will test the resilience of a long-lasting rebound in housing demand; a rebound which started back in late 2011 and has been uninterrupted. On the manufacturing side, the preliminary US manufacturing PMI for January will be among the first indications exhibiting the "pulse" of the economy this year. Barring the event of a significant retracement in activity below the 54 level, the manufacturing PMI will most certainly align with the reflationary scenario. In addition, global markets will confront the US GDP report for Q4 2016, where some considerable slowdown is expected by analysts. However, some prominent econometric models, such as the GDPNow model used by Atlanta Fed, are expecting a significantly higher annual growth rate than the tepid 2.2% consensus rate. This makes the GDP report a potential source of volatility given the wide range of expectations, with the risks for the US equity markets being to the upside.

Economic Calendar

Source: investing.com

Apart from the US figures, this week will provide a bigger picture of where the global business cycle is headed within 2017. A series of critical manufacturing and services PMIs for the month of January will be released in the Eurozone. The latest trend of these PMIs has been to beat analysts' expectations in most cases, providing relief in European equities as well as sovereign bonds. If this trend extends in early 2017, as well, then the euro (NYSEARCA:FXE) will get strong inflows in support of its new revaluation trend against most of its trading peers. Should such an unexpected development arise, the single currency will definitely take its revenge, and move in a big contrarian way against the negative sentiment circulating across media and traders.

However, it is not only the euro a currency which assisted greatly its economy to stand on its feet. The Japanese yen (NYSEARCA:FXY) which recently followed a strong devaluation trend against the rest of the world, might also help deliver some additional positive surprises. Should a solid increase in December's Japanese exports and trade surplus materialize, global risk assets will start feeling more confident about the reflationary scenario, given Japan's geographically dispersed export destinations.

This week's critical global releases will definitely shed some light on how the conundrum between the fading out of the Trumpflation trade and soaring inflation expectations plays out. Is the US TIPS market correct in insisting that the global economy is heating up for good? Or the prominent investor's voices will get their vindication?

One thing is beyond doubt; no one can persistently ignore the underlying short-term cycle of the economy and bet against it for too long. After all, savvy investors are fully aware of the grand rule of survival in financial markets; it is not enough to capture the right direction of asset prices in order to be profitable. Equally importantly, trades must be correctly timed.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The views expressed in this article are solely those of the author, provided for informative purposes only and in no case constitute investment advice.

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