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Did The Fed Policy Shift Destroy The Reflation Trade?

Trades that benefit from higher inflation made a sudden U-turn following the hawkish announcement from the Federal Reserve last week. Gold sank, the yield curve flattened aggressively, breakeven inflation rates collapsed, the U.S. dollar rallied, industrial metal and agricultural commodities plunged, and financial and energy stocks underperformed.

What did the Fed do or say to cause investors to jump ship on the reflation theme?

Until last Wednesday, Fed Chair Jerome Powell had repeatedly stated officials were not even “thinking about thinking about” tightening policy accommodation. The Fed was convinced that the current inflationary pressures were “transitory” and assumed inflation would eventually revert to the Fed’s 2% target once the economy normalized.

They are starting to question that assumption.

“As reopening continues, shifts in demand can be large and rapid, and bottlenecks, hiring difficulties and other constraints could continue to limit how quickly supply can adjust raising the possibility that inflation could turn out to be higher and more persistent than we expect,” Chair Powell said in the press conference following the meeting.

Wait. That sounds like inflation may be more of a problem that originally thought, doesn’t it? So why did the market punish positions that typically would benefit from the continuation of higher prices?

What spooked investors was the Fed’s response to non-transitory inflation. “If we saw signs that the path of inflation or longer-term inflation expectations were moving materially and persistently beyond levels consistent with our goal, we would be prepared to adjust the stance of monetary policy,” Powell added.

Given the adjustment in the “dots” for 2022 (7 members signaling a hike vs. 4 in March), it appears that many Fed officials believe the recent 5% CPI print qualified as material and post-pandemic changes to the labor market suggest higher prices will persist.

Market participants knew “thinking about thinking” about tapering QE purchases would eventually turn to “talking about talking” about changing policy. The Fed is expected to announce plans later this summer detailing plans to begin reducing asset purchases as soon as the end of this year. The change in stance happened to come sooner than expected and surprised investors. Tightening financial conditions early means the Fed will likely have to tighten less later. It also means less monetary stimulus could cut the economic recovery short, reducing demand and the “right tail” for inflation.

It was just last January when the Fed Chair said “we’d welcome higher inflation.” Considering the popularity of the reflation theme, helped by the Fed’s promise to let the economy “run hot”, the shift in policy prompted investors to liquidate reflation bets.

By voicing its concern over the recent spike in prices, and vowing to act before it was too late, the Fed lowered the probability of run-away inflation. Understandably, this alters the narrative. But inflation has not been conquered. Anybody looking to buy a house or business trying to import a container of goods from Asia can tell you prices are soaring and costs are rising. Wages are accelerating, supply bottlenecks still exist, more fiscal stimulus may be on the way and pent-up consumer demand is yet to be satisfied.

The violent moves in reflation trades last week are probably due to their popularity and overweight positioning, not their efficacy. Yes, some of the upside for certain assets may be reduced, but the macro picture has not changed that much. Real yields are still deeply negative and the global economy is in the early stages of an expansion fueled by what seems like endless fiscal support. The risk of higher prices is still present. The policy shift by the Fed hurt the reflation trade, but it did not destroy it.

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