Reflation Trade Heating Up

In this first trading week of 2021, a new investment theme appears to be emerging. That theme can be summed up in a single word – reflation.

A resurgence of inflation is being priced into asset classes across the board. Stocks are rallying to new records. Shares of Tesla and alternative energy companies are going to the moon. Marijuana stocks are suddenly back in vogue. Bitcoin is going bonkers.

Crude oil, copper, and other commodities also started to break out this week. But precious metals markets pulled back sharply this morning on the heels of a bad jobs report, meaning these markets require more time to work their way back up to last year’s highs.

President-elect Joe Biden is vowing to make good on President Donald Trump’s promise of $2,000 stimulus checks to most Americans. Biden also intends to push a $4 trillion “Build Back Better” agenda centered on “green” infrastructure programs.

Senate Republicans will have less leverage to block Biden’s spending ambitions. On Tuesday, Democrats picked up two Senate seats in Georgia to deny Republicans a majority in the Upper Chamber.

The prospect of a Democrat-controlled government is being greeted with surprising enthusiasm by investors. The prevailing thinking seems to be that more government spending and more cash injections into the economy mean higher asset prices.

But the bond market is starting to warn of potential risks looming.

Bond yields broke higher this week. The 10-year Treasury yield climbed above 1% while the 30-year long bond exceeded 1.8%.

These yields are still quite low, historically speaking. The problem is that even relatively mild increases in current rates cause bonds previously issued at lower rates to lose value.

Not only do those bonds not pay enough in interest to keep pace with inflation. But holders of them also stand to suffer capital losses to boot.

The Federal Reserve now faces a conundrum. It wants to keep interest rates suppressed across the yield curve. At the same time, it also wants to raise inflation rates.

Inflation is ultimately a destructive force for holders of cash and fixed-income instruments. At the same time, inflation can be a boon to bond issuers and other debtors – gradually bailing them out by enabling to pay back what they owe with steadily cheaper dollars over time.

The U.S. government is the world’s biggest debtor. So, it’s no surprise that there is a bipartisan consensus in Washington in support of the Federal Reserve’s inflationary policies.

The Fed is the largest single holder of government bonds. Its unlimited appetite for Treasuries has helped keep a lid on long-term yields, even though it doesn’t directly determine them like it does the Fed funds rate.

With the federal government set to undertake trillions more in borrowing in 2021, the central bank will have its hands full.

The Fed wants to have its cake and eat too – propping up the bond market while enacting policies that erode bond values. Higher inflation and artificially low interest rates are not a stable combination.

Eventually, something has to give.

Manipulating the gigantic bond market means thwarting free market pricing of inflation risk. But even if the authorities are successful in a particular interest rate rigging mission, the realities of inflation risk will simply get reflected elsewhere – whether in stocks, commodities, precious metals, or cryptocurrencies.

Some asset classes may respond to inflation more immediately; others may respond more dramatically over time.

Typically, the “good” effects of inflation are felt first, lifting financial markets. Then the painful side effects of price increases hit the economy. That isn’t so good for consumers or most businesses.

Then when wider public concern over inflation risk sets in, financial assets tend to lose favor versus hard assets. The ultimate safe havens of gold and silver tend to assume a leadership role in the inflationary melt up – and in the late stages they can go parabolic.

It appears as though some sectors of the stock market, along with speculative assets such as Bitcoin, are now entering blow-off phases. Perhaps they’ll continue to go up for a while longer. Even if more upside remains, these inflation-driven run ups could ultimately end badly for buyers who chase them at current sky-high prices.

Meanwhile, the bull market in hard assets may just be warming up.

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