Reflation Trade Is Back

A much softer than expected US January jobs report didn’t prevent US equities from closing higher at the end of last week as the reflation trade kicked back in.  One of the biggest driving forces for markets was the growing prospects that much of President Biden’s $1.9 trillion fiscal stimulus plan will be passed, albeit via a process of reconciliation, which allows Democrats to circumvent the need to gain the support of at least 10 republicans. This contrasts with prior expectations that the final stimulus was going to be less than $1 trillion. 

Pushing stimulus through this way highlights Biden’s urgency to inject more spending into the economy but could come at the cost of hurting bipartisan policy efforts. The impact of expectations of increased fiscal stimulus is particularly apparent in the US rates market, with US Treasuries selling off and bear steepening of the curve.  Although higher US Treasury yields failed to give support to the US dollar (USD) there is still scope for a short covering rally, which could still help give the USD relief.     

At the beginning of the year the US jobs market took a hit from renewed lockdowns and surge in COVID cases; US January non-farm payrolls increased 49k, and December was revised to -227k from -140k while more positively the unemployment rate fell to 6.3% from 6.7% though this was flattered by a drop in the participation rate as less people were looking for work.  According to the payrolls report there are still 9.9 million more unemployed compared to pre-COVID levels.  As such, the weak jobs data added more support to Biden’s fiscal stimulus proposals.   

This week focus will likely turn more to President Trump’s impeachment trial in the Senate than economic data.  Key data/events this week include China’s credit and monetary aggregates (9-15 Feb), central bank decisions in Sweden (Wed), Philippines, Mexico (Thu) and Russia (Fri).  Among these the consensus is for only Mexico to cut its policy rate. Also in focus are inflation readings in China (Wed), US (Wed) and India (Fri).  UK GDP (Fri) and US Michigan sentiment (Fri) will also garner attention. 

The return of the reflation trade, rally in risk assets and decline in cross-asset volatility bodes well for emerging markets (EM) assets.  However, there are definitely various cross currents impacting asset markets at present especially with US Treasury yields rising, which could potentially support the USD and pressure EM local bond rates markets.  EM assets were clearly favoured towards the end of last year, and while the positive story has not dissipated, EM assets may take a pause for breath before pushing higher again.  

In Asia, the Chinese-new-year holidays this week may dampen activity while China’s PBoC also appears to be limiting liquidity injections around the holidays, which could limit some of the gains in Chinese and impact China linked assets.  Chinese authorities have re-focussed attention on preventing an excessive build-up of leverage and credit metrics have peaked as a result.  As such, they may be less keen to inject a lot of liquidity into markets at present. 

Chinese Data Softens

It was a tough week for risk assets last week as stocks dropped, volatility increased and the battle between retail investors and hedge funds intensified, with the latter on the losing side. The end of the week saw US and European stocks drop.  Whether the decline in stocks is due to over extended valuations, vaccine variants, vaccine supply pressures, weak activity data or more likely a combination of all of these, asset markets go into this week on a more unstable footing, with risks skewed towards pull back extending further.  It’s hard to blame day traders for the drop given that most of activity from retail traders is buying of stocks, and now silver, with heavy short position, but they are likely contributing to the rise in volatility.  The US dollar (USD) could be a key beneficiary given the massive extent of short positioning in the currency.

Data in China is showing some softening in momentum.  China’s Jan official purchasing managers index (PMI) kicked off this week’s data and event schedule yesterday, with both the manufacturing and service sector PMIs disappointing expectations; the manufacturing PMI fell to 51.3 in Jan (consensus 51.6, last month 51.9) and services to 52.4 in Jan from 55.7 previously.  China’s softer PMI once again contrasted with a series of Asia manufacturing PMIs, released this morning. Later today the US Jan ISM manufacturing index is likely to register a modest decline (consensus: 60.0 from 60.7 previously). Also in focus today is India’s budget announcement, with the Fiscal Year 2021 budget deficit likely to be around 6-7% of GDP, much higher than the original 3.5% estimate.  

Over the rest of the week there are interest rate decisions in Australia (Tuesday), Thailand, Poland (both on Wednesday), UK (Thursday) and India (Friday).  Among these the Reserve Bank of India has the most potential for a surprise relative to market expectations, with a rate cut likely.  The highlight of the week is likely to be the US January jobs report at the end of this week (consensus 55k).  Deliberations on US fiscal stimulus will also be in focus, with a group of 10 Republican Senators writing to President Biden with a $600 billion stimulus proposal, well below the $1.9 trillion put forward by the administration.  Democrats have hinted that they may push through stimulus via reconciliation, which not require Republican support in the Senate, but such a move would likely sour any mood of cooperation in the Senate. 

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