Investors might be giving up on the so-called reflation trade too soon, according to Deutsche Bank.
It isn’t like investors are oblivious to risks on the horizon. In a Thursday note, Deutsche Bank economists acknowledged that the market has learned to contend with geopolitical tensions and quantitative easing from the European Central Bank and the Bank of Japan.
Indicators measuring inflation expectations have dropped sharply and “overreacted” to U.S. President Donald Trump’s policy setbacks, said the Deutsche Bank economists. TIPS break-evens, a gauge of the amount investors must pay to hedge against the risk of inflation, have fallen to their lowest in 2017. And spreads between 2- year
and 10 year Treasury notes
shrunk to 100 basis points, making for the flattest yield curve since Nov. 16, a possible cue that the market thinks the reflation trade is done and dusted.
Investors have run out of patience waiting for the Trump administration to find its feet and put in place business-friendly policy measures. Political infighting with the Republican Party and a failure to reach across the aisle has prevented Trump from passing pro-growth policies in Congress. But the Deutsche Bank economists warn that inflation isn’t just a function of domestic politics.
“Further progress in this direction is not reliant on the passage of new fiscal stimulus measures in the U.S., and the possibility of a significant overtightening [of the labor market]—again especially in the U.S.—tells us that inflation risks are now very much on the rise again,” they wrote.
Continuing jobless claims fell to a 17-year low and the unemployment rate has declined to its lowest level since 2007. Though Wednesday’s Beige Book reported fatter pay packets had yet to translate into inflation, a buildup in wage growth would eventually break into higher consumer prices, the economists said.
“While much of this resurgence is driven by the rebound in energy and other commodity prices over the past year, labor markets have been tightening impressively despite relatively moderate rates of output growth,” they wrote.
But predictions that less slack in the labor market would drive up inflation have historically failed to pan out, as the traditional relationship between the two economic variables broke down over time. The Phillips curve, an economic theory that says prices fall if unemployment picks up, or vice versa, appears less valid in an era of depressed economic growth.
“This development has generally not set off inflation alarms because the response of U.S. wage and price inflation to movements in slack have been relatively subdued in recent decades,” the economists said.
Yet statistical analysis from Deutsche Bank showed the original relationship between the two factors had appeared to strengthen recently, and that unemployment trending below a level known as the non-accelerating inflation rate of unemployment, or NAIRU, could stir up modest inflation. The NAIRU is how economists refer to the Goldilocks range for the jobless rate, too high to spark runaway growth in consumer prices and too low to require the Federal Reserve to hike its benchmark interest rate.
The Deutsche Bank economists admitted the biggest risks to their forecast include a scenario in which continued slack in the labor market is sufficient to keep a lid on wage inflation. Another risk is that inflation expectations remain depressed.
“Even so, these negative risks can be easily overstated in view of the fact that good progress is being made in removing slack from the labor market,” they wrote.