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 Lynch.
"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.
"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 Investment Management.
"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, too.
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 London.
"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 year."
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 trade." (Reporting by Tom Porter)