The reflation trade. We hear about it quite often as that force which has driven cyclicals higher and defensive sectors lower. It has been accompanied by the long dollar (NYSEARCA:UUP) and short Treasury (NYSEARCA:TBT) trade as the "reflation" and subsequent growth drive this pairs trade.
Good times, right? Here's the thing: one thing I have learned over time is that when everyone is on the same side of the boat, eventually it will take on water. Keep your eyes open and watch the water for signs it's time to get to the other side of the boat.
As long dollar is part of the bigger pairs trade, let's take a look at the dollar.
Versus the euro:
Versus the pound:
Versus the yen:
Versus the Canadian dollar:
Versus the Aussie dollar:
And versus the franc:
As the charts above show, leveraged funds have begun to unwind the long dollar leg of the trade. Keep in mind that they have been the drivers of this trade and have forced the asset managers to pile in and pile on. If they have begun to unwind, will this bottleneck the "reflation trade"?
The premise of this trade is that the switch from monetary policy to fiscal policy will create growth and, yup, inflation. Another thing we have to keep our eye on, then, is expectations for inflation.
First, a look at TIPs (NYSEARCA:TIP), as these will help show inflation expectations as seen through real yields:
Shorter term, over the last year:
The TIPs charts above are starting to show that inflation expectations are being lowered as they are reflected through real yields. Not encouraging.
One of my favorite charts for rates is the term premium, which reflects the compensation required by investors for the possibility that their expectations will prove to be wrong.
After spending time in negative territory (which I call complacency, as the only thing that is certain in investing is that things will change), after the election the term premium turned and finally went positive. Recently, however, the following has occurred:
Finally, a look at forward inflation expectations through the five-year, five-year forward inflation expectation rate:
As I see it, the long dollar trade has a chance of rolling over further as leveraged players unwind and expectations of inflation have been getting weaker, throwing the reflation trade into question.
And what sectors could be affected? Why, the same sectors that have benefited.
Since the potential "beginning of the end":
Obviously, I cannot say the reflation trade is played out, nor am I saying it is over - I am merely reflecting the data and what it might be saying. Like I said, when too many people are on one side of the trade (boat), if you aren't paying attention you are going to want to get ready to start bailing.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UDN over 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.