Does The Return Of The Reflation Trade Have Legs?

The Treasury market’s inflation forecast broke above its pre-pandemic high this week, fueling speculation that a new era of firmer pricing pressure is dawning. Maybe, but there are still good reasons to remain cautious before declaring that inflation is at a critical turning point. There’s a case for reviving the pre-pandemic outlook for roughly 2% inflation, but expecting a substantially hotter run still relies heavily on guesswork and dismissing the secular trends — an aging demographic, disinflationary pressure via technology, and other factors — that have prevailed over the past 20 years.

In the grand scheme of inflation analytics, the yield spread between nominal less inflation-indexed Treasuries is a popular bellwether of Mr. Market’s real-time expectations, but it’s hardly flawless. Using the market’s implied inflation estimate via 5-year maturities, for example, has had its issues over the years relative to official inflation statistics. The biggest gap was in 2008, when the market priced in a hefty bout of deflation. The annual pace of the core Consumer Price Index eased substantially but never went negative.

Nonetheless, as general gauge of crowd sentiment, the Treasury market’s breakeven rate is still useful, albeit as a rough estimate. Its main value seems to be as a gauge for identifying broad changes in inflationary trends. Although the specifics of the market’s deep deflation forecast in 2008 was far off the mark, the persistent disinflation/deflation bias during that fateful year was generally accurate for identifying the shifting conditions in the economy overall and the inflation profile specifically.

By that standard, the rebound in the market’s inflation outlook tells us that the broad pricing trend is rebounding. The breakeven for the 5-year maturities rose to 1.76% yesterday (Dec. 2), the highest since the spring of 2019.

It’s premature to use this bounce as a high-confidence signal that inflation’s about to roar back in the near future. On the other hand, it’s a sign that disinflation/deflation pressure is easing. But this shift should be considered in context with recent history, including the Treasury market’s tendency to overshoot shifting inflation expectations.

Recall that in March the market’s inflation outlook plunged to just above zero, virtually overnight. The catalyst, of course, was the pandemic. Now the market is revising it’s outlook and pricing in inflation that’s roughly in line with the pre-pandemic forecast – just below the Fed’s 2% inflation target.

As in many corners of estimating future events, Mr. Market has a tendency for hair-trigger shifts. With that in mind, the latest reflationary bias in the Treasury market is less about anticipating inflation’s revival vs. correcting the market’s recent disinflation/deflation outlook.

But tomorrow is another day and if the Treasury’s forecast continues to rise there will come a point when an material increase in the inflation outlook is warranted. For now, the pre-pandemic inflation forecast of roughly 2% looks more compelling. But with the coronavirus resurgence roiling the near-term economic outlook, and a broad rollout of a vaccine several months away, even assuming a return to early 2020 inflation expectations comes with plenty of caveats.

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By James Picerno

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