The Reflation Trade Is Dead, Long Live the Reflation Trade

  • Doubts swirl around inflation bets driving markets -- again
  • Citi analysts point to iron, copper and oil as crucial clues

Look to commodity prices to diagnose whether the reflation trade that has helped propel global stock markets to heady heights is dead or alive.

So say analysts at Citigroup Inc., who pinpoint three key levels that will signal when markets have changed course. They are: when copper for three-month delivery drops to $5,550 a ton, iron ore falls back to $80 per metric ton and oil slides to $47 a barrel.

Too simple? That may be precisely the theory’s appeal. Reports of the so-called reflation trade’s death have been greatly exaggerated since it kicked into gear sometime in July, as a plethora of signals suggest it has and then hasn’t come unstuck.

The term refers to the basic notion that investors position differently when they’re awaiting growth and inflation than when they forecast prices to keep grinding lower.

January marked the beginning of the end of these expectations, if you study government bond yields and the U.S. dollar -- which have since recovered past their post-election peaks. Fans of small companies’ stocks called time on it in February. A look at the appetite for inflation-protected securities shows doubts reached a new pitch in March, while another theory holds the entire thing to be an over-hyped, seasonal blip.

Despite equity and credit markets that still exhibit joie de vivre, it’s in the context of the rout in raw materials that Citi analysts think the trade is faltering. They echoed counterparts at Goldman Sachs Group Inc. who warned on Monday that the recent commodities selloff “suggested the global reflation theme can be split” into two: a manufacturing story related to China and OPEC’s production cuts, and a services story driven by growth in the U.S. and Europe.

Strategy

In any case, Citi have hedged their bets with a strategy to take care of a reflation trade that could be faltering.

Owning shorter-dated bonds and steering clear of equities is the trade for the investor who want to bet on reflation but still get out quickly if it sours, according to Citi analyst Mark Schofield, whose note to clients said the softness in commodities provides a reason to fear a correction in stocks. “We would rather pay rates than own equities as our reflation trade for the time being,” he wrote.

Oil traded within 15 cents of Citi’s key level on Tuesday, while copper and iron ore would have to fall more than 5 percent and more than 9 percent respectively to invalidate the reflation trade’s three vital signs.

Real Demand

In this cacophony of reflation commentary, Citi’s raw-material trinity risks becoming yet another piece of noise, yet other analysts have made similar arguments.

Bloomberg News strategist Mark Cudmore made the case for focusing on energy prices in a note written ahead of Citi’s, but addressing the same weakness in commodities. “It’s hard for inflation to keep accelerating when input prices are slumping,” he wrote. “It also suggests that real demand is not growing as quickly as hoped, which provides caution on economic optimism.”

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