Is the reflation trade back?
You might be inclined to think so based on the rise in 10Y yields over the past couple of sessions and more specifically, based on breakevens:
A lot of this appears to be down to stimulus hopes in China and, of course, the fillip crude got on Tuesday from news that the Saudis are “comfortable” with prices at $80. Here’s the BCOM:
It’s artistically fitting that Li Keqiang was the one to say China won’t devalue its currency to boost growth. Because what they probably *will* do to prop up the economy entails pushing the Li Keqiang Index, a gauge of the “old” industrial economy, higher.
But is the reflation trade truly rescued? Probably not, according to Nedbank’s Neels Heyneke and Mehul Daya.
Regular readers are familiar with the Nedbank duo for their work this year on the looming dollar liquidity crunch. In their latest note, they argue that rumors of the reflation trade’s demise are not greatly exaggerated.
To support their contention, Heyneke and Daya cite their “reflation trade indicator” which is basically just an equal-weighted index of positioning in commodities, equities, bonds, EM FX, gold, the VIX and the dollar.
“The indicator gives us a reasonable sense of investor confidence towards risk assets in general, ie, bullish/bearish sentiment towards risk assets”, they write, in a piece dated Tuesday. Here’s the indicator rolling over:
“Our view, supported by investor positioning towards risk assets, was at an extreme [and] this made us pay special attention because such extremes can often be turning points”, Nedbank writes, describing their thought process in January. Heyneke and Daya continue as follows:
The ‘reflation trade’ indicator continues to lose momentum; we do not foresee a sharp reversal towards the ‘reflation trade’ for the remainder of the year.
Changes in positions [in the dollar and copper] among others indicate that investor sentiment has soured amid heightened fears of a global trade war, threatening global growth; a slowdown in China’s economic growth; and the US Federal Reserve continuing to tighten monetary conditions. Turmoil in emerging markets has worsened investor sentiment towards risk assets.
In case it isn’t clear enough, that’s a reiteration of the thesis that an ongoing and persistent squeeze in dollar liquidity will continue to exert tightening pressure across markets, leading to de-risking, with the recent turmoil in EM but one manifestation of a phenomenon that could well play out across assets going forward.
“There is a relationship between financial conditions (i.e., US dollar funding) and the ‘reflation trade’ indicator representing investor sentiment towards risk assets”, Heyneke and Daya observe, tying all of the above together in the course of describing the following visual:
So when will risk assets (and the reflation trade more generally) have the green light again? According to Nedbank, not while the following conditions are still in play:
- The Federal Reserve continues to hike interest rates and taper off its balance sheet
- China’s credit cycle remains on a downtrend
- Weaker commodity prices persist
- Fears of a global trade war and political tensions linger
- Global $-Liquidity remains under pressure
Perhaps China can address that second bullet point, but for the time being, Bloomberg Economics’ China credit impulse gauge continues to suggest that the key source of global credit creation is in decline.