LONDON, Feb 24 (IFR) - Improving economic data suggest the
much-hyped reflation trade of 2017 could begin to pay off in the
next few months, but some fixed income investors are being given
pause by policy uncertainty on both sides of the Atlantic.
The Great Reflation featured heavily in 2017 investment
outlooks, with analysts expecting central banks in the world's
biggest economies to face rising price pressures from improving
economic activity and mooted fiscal stimulus from governments.
Monthly flows into high-yield and equity funds - two popular
reflation plays - were positive for the second consecutive month
in January, having been negative for every month in 2016 until
December, according to figures from Bank of America Merrill
"Inflows continued across investment-grade short-dated and
high-yield funds in Europe as investors have been adding yield,
shifting away from duration risk," BAML's credit strategists
said in a note published alongside those numbers on February 17.
They also pointed to signs of recovery in equities inflows
as well as emerging market debt. And as rates rise, they expect
high yield and short-duration plays to outperform, with
resultant flows to follow that performance.
The reflation trade followed promises of fiscal expansion by
Donald Trump during his campaign. But the issue is being clouded
by uncertainty around both Trump's economic plan, and how it
might impact the Fed's thinking on rates this year.
UP OR DOWN
"Since Trump was elected there has been a consensus long
dollar, short rates trade that is still in place to some
extent," said Fraser Lundie, co-head of credit at Hermes
"Anecdotally the strong dollar seems to be acting as a
handbrake on over-exuberance in the markets and in the economy
as a whole."
And data from the Federal Reserve last month showed its
preferred core inflation measure was 1.7% in December - below
its 2% target - but core CPI accelerated to 2.2%.
Fed officials have struck a hawkish tone in recent weeks,
preparing investors for the possibility of multiple rate hikes.
"The market is pricing in two or three Fed rate rises this
year," said Lundie, "but there is probably more risk to the
downside of that estimate because of potential volatility linked
to Trump’s economic policy."
Investors are facing material policy uncertainty in Europe,
The Bank of England, seemingly unsure of the economic impact
of the UK's vote to leave the European Union, effectively threw
up its hands at its last monetary policy meeting on February 2,
with governor Carney saying he could see interest rates moving
in "either direction".
On the same day ECB chief economist Peter Praet said the
recovery in Europe was "not yet sufficiently robust" for a
tightening of monetary conditions, and that underlying price
pressures remained subdued despite eurozone inflation rising to
1.8% in January.
Investors appear to have heeded his advice. The euro 5y/5y
forward inflation swap - a proxy for market inflation
expectations - was at 1.76% on Friday.
Despite reflation being one of the most crowded trades of
2017, some participants believe the market has got it wrong.
One of them is Alex Eventon, a senior portfolio manager
running an unconstrained strategy for Dolfin Asset Management in
"Inflation is well underpriced by the bond market at the
moment," he told IFR.
"We see the 10-year Treasury yield heading above 3% this
year as the curve flattens, with the short-end underperforming.
The Fed is eager to get ahead of the curve and will become
increasingly responsive to inflation surprises."
"The ECB is forced to be less responsive and stay behind the
curve for now, and we see the 10-year Bund above 1% later this
The ECB will likely face more calls to address rising price
pressures in March as economic activity picks up. The eurozone's
PMI manufacturing index accelerated to 56.0 in February, having
hovered around 53.0 for much of 2016.
Pimco also believes a decade of stagnant prices since the
global financial crisis may be blinding market participants to
the threat posed by improving data.
"We believe investors are not adequately pricing
above-target future inflation as they are still anchored by
several years of below-target inflation," said the firm in its
2017 investment outlook, published at the end of January.
But Hermes' Lundie is much more sanguine about the rising
rate threat to fixed income portfolios.
"I'm not convinced the market is flying blind on rising
inflation," he said.
"This environment makes me constructive on certain areas of
fixed income, such as emerging market investment-grade bonds,
because they will benefit from the downside of the long dollar
(Reporting by Tom Porter)