What do markets believe?

The November 2016 election gave “birth” to the “reflation story”. There was a lot of excitement, with long-term yields, the dollar, stocks and inflation expectations all rising.

But this is illusory. Since mid-2014, the economy was testing new depths. Soon after Janet Yellen took the helm, the Fed embraced the “tightening talk”. In late 2015, it even went ballistic, raising rates for the first time in 10 years and saying it expected rates to increase at least four times during 2016. The market reaction was a “bloodbath”. That forced the Fed to turn tail, so in the spring the markets began to recover those losses, although treasuries had to wait until the summer.

The election of Trump gave confidence indicators a boost. However, is the “reflation story” for real?

When you put things into perspective, it seems not. The chart illustrates.

In 2013, Bernanke introduced the “taper talk”. To investors, that could well mean the Fed expected a recovery to take hold. Spreads widened. Janet Yellen, taking over from Bernanke in early 2014 quickly put those “fears” to rest.

The point is that the economy is not materially different now from what it has been for the past seven years. Since it is hard for many to believe the economy has been so bad for so long, an event like Trump president could easily be a harbinger of change. His first ten days in office, however, do not bode well.

There´s little room for optimism. In its latest meeting, the Fed was less hawkish than expected. But markets seem to not pay much attention given the “new view” that economic assessment is not one of the Fed´s strengths!

The bigger picture is that the 2% inflation target is a ceiling on projected inflation, but the Fed controls the projections.  And its projections remain low in quality and always bearish, a nasty combination that gives the nominal economy little room for flexibility. The market knows this, but cannot escape that trap unless the Fed is ordered to change.

There has been some discussion of changed targets, e.g. over the measurement of unemployment, and this is encouraging. Trump and his new Treasury team need to be even bolder. NGDP Targeting, Level Targeting (NGDPLT) would promote both stability and growth, the twin goals of all.

As things stand, it won´t be at all surprising if at year end the Fed will have increased rates only once, once again.

What does that tell you about returns from “reflation trades”.


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