FOR SEVEN month most investors sang the same uplifting song. Since Pfizer and BioNTech published the positive results of their covid-19 vaccine trials last November, the way to make money in the markets has been to bet on a roaring rebound in the global economy, so that pent-up demand for everything the pandemic denied people – vacations, dining out, shopping – has gone wild. This “reflation” trade has raised the prices of commodities used in construction, such as copper and lumber, to record highs. It has lifted global stocks, especially the stock prices of companies hardest hit by the pandemic, such as cruise lines and retailers. Emerging economy currencies, which tend to benefit more than most from the global economic strength, rallied against the dollar and the euro. Bond yields have climbed, alongside expectations of rapid growth and higher inflation.
That seemed to change on June 16, after the Federal Reserve, until then seemingly optimistic about rising U.S. inflation, suggested it might consider raising its policy rate, long pegged to zero. Shorter-term bonds and stocks fell, as did the building boom’s commodities. That nervousness was eased somewhat on June 22 when Jerome Powell, the chairman of the Fed, stressed that the central bank would remain patient and allow the economy to fully recover from the pandemic. But investors are wondering if the big reflation trade is over.
The enthusiasm of recent months has been supported in part by the assumption that the Fed will maintain the same very accommodative monetary policy. Hence the concern when Mr Powell suggested that the central bank might have to consider tightening “a little earlier than expected”. The Fed has raised its inflation forecast and raised its median estimate for the future of key rates to include two increases in 2023. Mr Powell also said the Fed will start discussing when to slow down its asset purchases. compared to the current $ 120 billion per month. This change of tone was reinforced two days later when James Bullard, chief of the St Louis Fed, said CNBC that the first rate hike could happen at the end of 2022.
The Fed had appeared nonchalant even as signs of the overheating US economy became harder to ignore. A measure of inflation that the central bank is watching closely, “core PCE», Jumped to 3%, year-on-year, at the end of April. Headline inflation, measured by the consumer price index, fell from less than 2% in February to 5% in May. Anecdotal evidence of overheating abounds, from the burning housing market to soaring grocery bills, gas prices and Uber fares. Still, Fed officials said the acceleration in inflation was “transient” and that they would examine its effects. Investors believed them.
They were therefore surprised by the change in tone. Many of the trends that have dominated the markets since November have unwound. Reflecting expected rate hikes, the yield on two-year Treasury bonds jumped to 0.27%, from 0.16% on June 14 (see chart). The 30-year yield, which tends to follow long-term growth or inflation expectations, fell to 2.02% on June 18, from 2.21% before the Fed meeting.
The prospect of the Fed curbing inflation and growth weighed on stock and commodity prices. Value stocks, which had performed particularly well since November, were hit hard. Copper lost its spark, losing 8% over the week. Wood was felled, down 15%. the S&P 500 slipped near a record high, ending the week down about 2%, although it has since recouped those losses, in part thanks to Mr. Powell’s soothing words on June 22.
The Fed has also upset monetary policy makers elsewhere. During the last unwinding of a post-crisis stimulus package, in 2013, the Fed triggered a famous “taper tantrum” during which many emerging market currencies fell sharply against the dollar. On June 16, the Brazilian central bank raised its interest rates from 3.5% to 4.25%, the third increase since February, despite the damage caused by Covid-19 to the Brazilian economy (and to the health of Brazilians). In Hungary, the central bank raised interest rates by 0.3 percentage point on June 22, slightly more than expected. It was followed a day later by the Czech National Bank. Central bankers in developing countries fear that a more hawkish Fed could weaken their currencies, exacerbating their inflation problems.
The question investors now face is how much the Fed’s stance has really changed. It now appears that the initial reaction to the Fed meeting was overblown. When many investors hold the same portfolio of positions, they may be forced to bail out quickly if the markets move violently against them. This liquidation of positions can exacerbate volatility. In fact, there is reason to believe that the big reflation trade has yet to unfold: The reopening of the US economy is only in its infancy, the end of 2022 is far away, and Mr. Powell still seems fear a too rapid tightening of policy. .
But those who turn their backs on emerging market currencies, value stocks and copper will have enough to convince themselves that the economy is about to slow again. Lumber prices were already down before the Fed meeting, as the frenzy for home improvements died down. Credit card spending, an early indicator of economic activity, was 20% higher than two years ago, but this month the pace slowed to 16.5%, according to Bank of America. Soon, investors will know which bet pays off next. ■
This article appeared in the Finance and Economics section of the print edition under the headline “Fed urges change of mind”