26th Mar 2021 by Mark Scher

What is the Reflation Trade?


The financial press has been discussing the ‘reflation trade’ over the past couple of months. But what exactly does this mean?

The financial press has been discussing the ‘reflation trade’ over the past couple of months. But what exactly does this mean? It is a term that represents a return to global growth after the devastating economic impact of COVID-19. On approximately 9 November 2020, the first highly effective vaccine came to market. Since then, risk assets (equities) have soared with little ebbing . With vaccines in the marketplace throughout the developed world and Central Banks being overly accommodative, these factors give even more fuel to those betting on the improving economic cycle.

With the US Fed holding short-term rates at or near 0.00% , why are bond yields rising? Below is a chart looking at the US Treasury Yield Curve at various dates; what should jump out is that the yield curve is steepening. This can be seen by the difference between the blue line represented by the yield curve as of the first trading day of 2021 and the yellow line of 16 March 2021. This means market participants are pricing in an economic recovery, ergo, reflation. So what stocks are poised to do well in this reflationary period? The typical stocks would be banks, cyclical industries, emerging market stocks, and commodities.

Source:  U.S. Department of the Treasury, as of 16 March 2021; https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yieldYear&year=2021 

Based on Treasury yields and ultra-low short-term rates, the spread between 10-year and 2-year treasuries is expanding. Below is a graph showing the spread since the beginning of 2015:

Looking at all this data, one can assume that there is a good chance that inflation may be coming back to haunt investors. The best way to view the chances of inflationary pressures are through the lens of an economic tool I used back in university, the Equation of Exchange.

M * V = P * Q

        M = The money supply
        V = Velocity or how many times a dollar is spent purchasing finished goods and services
        P = Price level of all finished goods and services in the economy
        Q = The quantity of all finished goods and services sold in the economy

Another way to look at this equation is who it represents: buyers on the left and sellers on the right.

Some of these terms require additional explanation.  The money supply can be represented by M1 or what is referred to as the money stock.  It seems from the graph below, that the US is awash in money thanks to the Central Bank and the US Government interventions.

As of 17 March 2021

Velocity is different for each person and is based on spending patterns.  For instance, those who save their cash would have a low velocity of money.  In comparison, those who spend their money at a fast rate have a high velocity of money.  Overall, the long-term velocity has averaged somewhere around 7 and this number generally doesn’t change all that much in a given year.  However, there have been times when the ratio has been 4 and others when it is 10.  This pandemic has dramatically slowed spending on final goods and services (being those goods and services available for purchase by the intended user without any alterations required), as is shown in the chart below:

As of 17 March 2021

Price does not need much of an explanation.  However, the quantity of goods and services does.  Quantity in the equation represents real Gross Domestic Product (GDP).  When quantity is multiplied by price (i.e., the right side of the equation), you get nominal GDP.  Real GDP is a better measurement as it accounts for the effects of inflation or deflation.

Real GDP does not change that much each year.  Suppose we were to have a 10% increase in real GDP, that would-be unheard-of growth.  On the other hand, if we had a decline of 10% in real GDP, that would be akin to the Great Depression.  As stated above, velocity does not change all that much in a single period.  =Given velocity and quantity do not move very sharply, these variables have less impact on large and sustained changes in price levels.

Therefore, we are left with M = P.  This tells us as the supply of money goes up, so will the price of finished goods and services.  The result is inflationary.  As an example, a one percent increase in the monetary supply growth will equal a one percent increase in the inflation rate.  In our opinion, this leads us to three basic principles:

  1. In the long run, money is neutral, meaning a doubling of money supply will equal a doubling of the prices.
  2. Looking at sustained increases of inflation boils down to what Milton Friedman said many years ago, “Inflation is always and everywhere a monetary phenomena.” 
  3. Since Central Banks have significant control over a nation’s money supply, they also have considerable control over the inflation rate.

Why is it a problem if prices are going up?  For consumers, that means spending more on the same products.  However, prices include wages, meaning wages will also increase.  

In the end, a steepening yield curve and prices rising mean the economy is on the mend and looking forward to more normalised growth.  We believe after the tumult of 2020, investors should feel optimistic about the prospects for recovery and reflation, even if there are inflationary considerations along the way.

 [1] https://www.pfizer.com/news/press-release/press-release-detail/pfizer-and-biontech-announce-vaccine-candidate-against
 [2] https://finance.yahoo.com/chart/
 [3] https://fred.stlouisfed.org/series/FEDFUNDS


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