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MACRO VIEW COLUMNS: Markets Aren’t Crazy to Embrace Reflation Trade, Yet

(Bloomberg) — There’s an oft-quoted cliche that the definition of insanity is trying the same thing over and over expecting a different result. Another aphorism puts it slightly differently: fool me once, shame on you; fool me twice, shame on me. Financial markets seem to be in the throes of another love affair with the U.S. reflation trade as the dollar, bond yields, and small-cap stocks have all enjoyed a stellar September. Are markets crazy to succumb to another bout of tax-cut fever? Perhaps, and it will be important to keep track of how much good news on the fiscal front is in the price. However, investors should also remember that there are plenty of sane reasons why markets reflated this month.

  • For the past few weeks markets have been operating from the November 2016 playbook. Sell tech stocks and buy small caps. Buy dollars against other major currencies. Sell bonds and buy inflation breakevens. Those trades all performed well for a few weeks and then suffered for much of 2017. Are traders cruisin’ for a bruisin’ again?
  • At this point it’s pretty early in the game to quantify how much of recent market developments represent optimism over favorable U.S. fiscal policy outcomes. Probably the best way to isolate this factor is to look at the performance of high tax firms versus the broader index. While companies with higher-than-average tax rates have outperformed recently, on an aggregate basis they are still slightly down since just before the election
  • The rise in bond yields has been notable, but it’s important to remember the starting point. August ended among concerns over the economic impact of the recent hurricanes and left the Treasury market badly overbought and traders overly pessimistic about the Fed. To a large degree the recent rise in yields has been about unwinding unrealistic expectations, a process that may be largely complete for the time being
  • As for the dollar, it may be a coincidence that it started its recovery when USD/CNY hit 6.50 and the PBOC made it easier to short yuan — but probably not. Obviously yields will remain a significant driver of the dollar’s fortunes, so it’s important not to get too bullish too quickly
  • At the end of August there was clearly too much pessimism priced into Treasury yields and the dollar. Much of that has now been unwound. Recent trends can continue without raising too much of an eyebrow — say, 10- year yields to the 2.40-2.45 level. Absent a fresh catalyst, however, pushing beyond there will require buying into the same narrative that failed so badly earlier this year. While that might not be crazy, there’s no guarantee that it’s sane
  • NOTE: Cameron Crise is a macro strategist who writes for Bloomberg. The observations made are his own and are not intended as investment advice.

To contact the reporter on this story: Cameron Crise in New York at ccrise6@bloomberg.net

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