Return of the Reflation Trade?

Over the past week we have seen bond yields move higher. This has included an almost doubling of the German 10-year bond, from 0.25% to 0.46%; of the U.K.’s, from 1% to 1.25%; Canada’s, from 1.47% to 1.77%; and to a lesser extent U.S. Treasuries, from 2.14% to 2.28% (first chart). Now, we may be early, as one week does not make a trend. But after bond yields moved higher from last summer through early 2017, we have seen this trend of higher yields reverse over the past few months.

Softer economic data and lower commodity prices caused many to question whether the reflation trade of 2016 was over. But is it? We don’t think so, and the reasons are as follows.

Economic Data May Support Return of Reflation Trade

There is no denying the world was seeing stronger economic data in the second half of 2016 compared to the first half of 2017. You don’t even have to look very far. The U.S. economy expanded by 3.5% and 2.1% in the third and fourth quarters of 2016, respectively, and so far has posted a rather anemic 1.4% for the first quarter of 2017. This may be set to improve for a couple reasons.

  1. First-quarter U.S. GDP data has tended to be rather misleading over the past few years, notably showing weakness that does not continue for the year.
  2. Currently, second-quarter GDP, which will be released in about a month, is forecast to be 3.0%, a notable improvement.

Of course, the forecasts could be off, but for now we will give the consensus the benefit of the doubt. Plus, GDP forecast accuracy isn’t spot on, but is rarely woefully off.

This soft patch in the data can also be seen in the Citigroup Economic surprise indices. We included the big economic zones, namely the U.S., Eurozone and Asia in the second chart on the right. Rising trends in these indices certainly coincided with rising bond yields in the second half of 2016. Softness in the surprise indices during the first half of 2017 also coincided with flat to falling bond yields.

Now with the Eurozone starting to rise, plus Asia and the U.S. stabilized, we may start seeing a more reflationary environment again.


The big headline inflationary data still does not support the return of a more reflationary environment…yet. U.S. Consumer Prices (ex food and energy) has softened from 2.3% in January to 1.7% in May. A similar trend has been evident in the PCE Core, which garners more attention from the Federal Reserve. However, it is worth noting the market will always move ahead of these measures, which are backward-looking and delayed.

For more timely indications, the five -year inflation swaps appear to be reversing their downward trend and ticking higher. It’s still early, but we may be seeing a direction change.

Commodity Prices

This reflation to deflationary and potentially back to reflationary pressure also appears evident in commodity prices. While most measures of prices or inflation exclude energy given its volatility, it still impacts prices across many industries. Shippers include energy surcharges or pass it on in higher prices of goods that just can’t be adjusted. There was reflationary pressures from oil, measuring the year-over-year change in the second half of 2016. But then the course reversed in the first half of 2017.

Noticing a trend? Now we have energy prices sitting roughly where they were a year ago at this time. Let’s call this neutral, but importantly, the deflationary pressure has abated. And given oil prices remained range-bound in the second half of 2016 in the $40 to $50/barrel range, we would need to see a thirty-handle on oil for this to become a deflationary pressure again. Possible, but not our baseline outlook.


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