Higher-than-expected inflation has triggered a ‘reflation trade’ in markets recently, but the increases won’t last and investors should take heed.
A reflation trade happens when the economy experiences some inflation and the price of assets in the financial market move to reflect that—including when oil prices rise because economic demand is stronger.
Currently, the strength in consumer demand and prices has caught markets by surprise, given that the Federal Reserve has already lifted interest rates over the past year-plus to cool demand.
The consumer price index in both August and July rose just over 3% and beat expectations by a tenth of a percentage point in August. It is down from the just over 9% peak in the summer of 2022, but the recent strength has come on the back of strong economic demand, with retail sales continuing to grow.
Consistent with the sturdy demand—and part of the recent reflation trade— the price of oil has risen. WTI crude is up about 17% since a mid-August bottom to $91 a barrel. That has brought the
Energy Select Sector SPDR ETF
(ticker: XLE), an oil stock exchange-traded fund, up about 6%, better than the 2% gain of the
Long-dated bond yields also are higher. The 10-year Treasury yield has risen to 4.35% from an August low of about 4%.
And that is bringing the dollar upward in value because higher U.S. yields make the country’s fixed-income more appealing, attracting demand from global investors to own dollars. The U.S. Dollar Index (DXY) is up to 105 from an August low of 102.
The catch for investors is those moves have already happened—anyone looking to put money to work in markets today shouldn’t expect the reflation trade to continue.
As the Federal Reserve acknowledged at its annual Jackson Hole Economic Symposium in August, the dent to economic demand from higher rates often happens with a delay and could keep declining from here. That is reflected in the 10-year break-even rate, which shows the bond market’s expectation for average annual inflation over the coming 10 years. It is at about 2.35%, down from an August peak of 2.41%.
The expectation for waning demand reflected in that number suggests the price of oil may have already topped out. It last touched this level in October 2022, where sellers came in to knock the price lower. Right now, WTI crude isn’t cracking above $91. The oil stock ETF, in the low 90s in terms of dollars per share, is at a level where sellers have consistently knocked it lower many times since 2014.
And the dollar may have topped out, too. Every time it hits its current level since November 2022, it drops. On Monday, it was down a tick.
With the reflation trade looking as if it is already over, buying bonds instead of other assets is a smart move. Investors can lock in current yields before they fall. The 10-year yield is almost two percentage points more than expected annual inflation for the next 10 years. It could provide a solid hedge against any stock market or oil market risk.
Write to Jacob Sonenshine at firstname.lastname@example.org
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