FOR SEVEN months most investors have been singing the same uplifting song. Since Pfizer and BioNTech published the successful results of trials of their covid-19 vaccine last November, the way to make money in markets has been to bet on a roaring rebound in the global economy, as pent-up demand for all the things the pandemic denied people—holidays, dining out, shopping—was unleashed. This “reflation” trade lifted the prices of commodities used in construction, such as copper and lumber, to record heights. It lifted global stocks, especially the share prices of firms hardest hit by the pandemic, such as cruise operators and retailers. The currencies of emerging economies, which tend to benefit more than most from global economic strength, rallied against the dollar and the euro. Bond yields climbed, along with expectations of speedy growth and higher inflation.
That appeared to change on June 16th, after the Federal Reserve—hitherto apparently sanguine about rising American inflation—suggested that it may eventually think about raising its policy rate, long anchored at zero. Shorter-dated bonds and shares tumbled, as did those building-boom commodities. These jitters were soothed somewhat on June 22nd when Jerome Powell, the Fed’s chairman, stressed the central bank would remain patient and enable the economy to make a full recovery from the pandemic. But investors have been left wondering whether the great reflation trade is over.
The enthusiasm of the past few months was underpinned partly by the assumption that the Fed would maintain the same, super-loose monetary policy. Hence the anxiety when Mr Powell suggested that the central bank might have to consider tightening “somewhat sooner than previously anticipated”. The Fed raised its inflation forecasts and lifted its median estimate for the future of policy rates to include two increases in 2023. Mr Powell also said the Fed would begin discussing when to slow its asset purchases from the current $120bn per month. This change in tone was reinforced two days later when James Bullard, head of the St Louis Fed, told CNBC that the first rate rise could arrive in late 2022.
The Fed had seemed nonchalant even as signs of overheating in the American economy became harder to ignore. A measure of inflation the central bank watches closely, “core PCE”, jumped to 3%, year on year, at the end of April. Headline inflation, gauged by the consumer-price index, climbed from less than 2% in February to 5% in May. Anecdotal evidence of overheating abounds, from the piping-hot housing market to spiking grocery bills, gas prices and Uber fares. Yet Fed officials said the acceleration in inflation was “transitory” and that they would look through its effects. Investors believed them.
So they were surprised by the change of tone. Many of the trends that have dominated markets since November unwound. Reflecting the prospective rate increases, the yield on two-year Treasury bonds jumped to 0.27%, from 0.16% on June 14th (see chart). The 30-year yield, which tends to follow long-term growth or inflation expectations, tumbled to 2.02% on June 18th, from 2.21% before the Fed’s meeting.
The prospect of the Fed putting a brake on inflation and growth hit share and commodity prices. “Value” stocks, which had performed particularly well since November, were hit hard. Copper lost its spark, shedding 8% over the week. Lumber was felled, dropping 15%. The S&P 500 slipped from near a record high, ending the week about 2% lower, though it has since recovered those losses, partly thanks to Mr Powell’s soothing words on June 22nd.
The Fed also wrong-footed monetary policymakers elsewhere. When it last unwound a post-crisis stimulus, in 2013, the Fed set off a notorious “taper tantrum” in which many emerging-market currencies fell sharply against the dollar. On June 16th the Brazilian central bank raised its interest rates from 3.5% to 4.25%, the third increase since February, despite the damage covid-19 has done to Brazil’s economy (and to Brazilians’ health). In Hungary the central bank raised interest rates by 0.3 percentage points on June 22nd, a little more than expected. It was followed a day later by the Czech National Bank. Central bankers in the developing world worry that a more hawkish Fed will cause their currencies to weaken, exacerbating their inflation problems.
The question investors face now is how much the Fed’s stance has really shifted. It now appears that the initial reaction to the Fed meeting was overdone. When many investors hold the same portfolio of positions, they can be forced to bail out in a hurry if markets move violently against them. This liquidation of positions can exacerbate volatility. In fact, there are reasons to think the great reflation trade has further to run: the reopening of the American economy is still in its early stages, the end of 2022 is a long way off and Mr Powell still seems apprehensive about tightening policy too quickly.
But those turning their backs on emerging-market currencies, value stocks and copper will find plenty to convince themselves that the economy is about to slow once more. Lumber prices were already slipping before the Fed meeting, as a frenzy for home improvements cooled. Credit-card spending, an early indicator of economic activity, had been running 20% higher than it was two years ago, but this month the pace has slowed to 16.5%, according to Bank of America. Soon, investors will learn which bet pays off next. ■
This article appeared in the Finance & economics section of the print edition under the headline “The Fed prompts a change of heart”