Following the worst week for stocks since the US election, the reflation trade that was launched by the Trump election now appears solidly dead, with the dollar and commodities sliding, inflation expectations crumbling, and junk bonds – where investor euphoria had reached dramatic proportions – being hit the hardest. As Bank of America commented last Thursday, “the last few weeks we have seen wobbles in high yield; a full 2 months earlier than we anticipated. What began as the expected effects of rate risk on higher quality high yield bled to unexpected lower crude prices and a repricing of the Energy index by 87bp (5.98% to 6.85%) and has further morphed into an early second guessing of the optimism surrounding policy.”
Shortly after this note, political uncertainty soared when Republicans failed to pass the healthcare bill, leading to questions over the passage of Trump’s tax reform. As explained on Friday, with Obamacare repeal on hiatus indefinitely, Republicans now have to find a $1 trillion offset in budget savings, or else Trump’s tax cut will have to be slashed by a similar cumulative amount: hardly a catalyst to restore confidence in the reflation trade.
And yet, few are willing to throw in the towel on the most popular trade since November (which recently helped push the S&P to 2,400), and one bank went so far as to say that smooth sailing for Trumpflation remains: as Deutsche Bank’s Dominic Konstam wrote in his latest weekly fixed income piece, “we continue to expect higher yields and a steeper curve driven largely by tax reform and fiscal stimulus. We see scope for the Trump economic agenda to create a sort of “Keynesian accelerator” whereby a positive demand shock could induce greater domestic investment and, ultimately, higher productivity growth.”
And yet, cracks are starting to appear in this most optimistic of theses, because on the very same page, Deutsche Bank, which has been one of the biggest supporters of the bullish implications of the reflation trade – and has been quite bearish on Treasuries as a result – admits that in addition to Trump, there is another potential source of policy error:
There are naturally several avenues to policy error.
The first and most prescient at the moment is failure to pass key elements of the Trump administration’s economic policy agenda.
At the time of writing, markets seem inclined to look past the ongoing healthcare debate. The CBO’s scoring of Trumpcare’s savings relative to baseline has fallen from $337 billion to $180 billion, and anyway these “savings” are probably more material in providing a piggy bank to fund vote-winning amendments in the Senate debate than they are for funding corporate tax reform. Risk markets might flinch if Trumpcare fails to pass, but the far bigger deals for markets are tax reform and fiscal stimulus, and the experience of the Clinton administration suggests that an early misstep in healthcare won’t prevent the new administration from pivoting to other business. However, we note that the post election sell-off in bonds seems to presuppose a high probability that the administration will succeed in passing its legislative agenda, and that the measures will work.
Then there is the Fed. Aggressive hikes will push real yields and the dollar higher, both of which would be negative for commodities, breakevens, and risk more broadly.
The dots tell us that the Fed hopes to get to 2% by the end of 2018, which would put real rates more or less at zero. We still see a strong chance that the Fed “misses” at least one hike priced by the dots along the way this year to take pressure off of real rates, the dollar, and risk assets.
And while Deutsche Bank heavily hedged its cautious language, it is worth noting that as of the most recent Bank of America fund managers survey, virtually every trader is still on the same side of the Trumpflation trade, with managers themselves admitting that long USD, long banks, short TSYs remain the most crowded trades. That will not be the case for long if the dreaded “deflation monster” makes an appearance soon.
Furthermore, should sentiment indeed be shifting – as Deutsche Bank’s statement indicates – and should the market begin to reprice the threat of “policy error”, there is a long way to go before all of these massively stretched trades renormalize.