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Friday April 30, 2004 - 14:27:24 GMT
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Global Economy Reflates, Reflation Trade Deflates

Global Economy Reflates, Reflation Trade Deflates

Why is the "reflation trade" unwinding now that the global economy is

First of all calling the bet that US rates would stay low indefinitely, debasing the value of the dollar and ultimately generate high levels of inflation the "reflation trade" is not very exact. But first what is, or more accurately what was, the reflation trade?

Between the bursting of the stock market bubble in 2000 as well as highly optimistic notions of a new economy, and the fallout from 9/11 and war, deflationary risks emerged and drove the Fed (and most central banks) to ultra-accommodative monetary policy to avoid a Japan-like outcome of falling prices, falling consumption, zero business investment and economic stagnation/contraction. Behind cutting a firebreak around deflation the Fed's cheap money policy weakened the dollar, making hard assets like commodities (and commodity-based currencies) and precious metals the ultimate hedge against deflation in the near-term and runaway inflation in the long-term. The latter outcome, however, unlikely, was assumed to be the end game of combating deflation with ultra-accommodative monetary policy. In other words monetary policy aimed at nipping deflation in the bud would make fiat money worthless (in the worst case scenario). Like many trades, assumptions in the reflation trade were based on extreme outcomes. First deflation, then hyperinflation. Events that are statistical outliers.

The reflation trades were popular in 2003 and started to unwind, first with the dollar, in February and March, and more recently with commodities.

What happened? Well first of all deflation was avoided. For some in the market it takes Alan Greenspan reaching this conclusion before any thought of exiting a reflation trade can occur. So when Greenspan noted last week that the risk of deflation was most definitely over, and a normalization in monetary policy in order, if in due course, the commodity part of the
reflation trade largely unwound. But the FX part was unwinding as noted above from March especially (crow barred out arguably by unprecedented intervention by MoF). Yet the key driver in the unwinding of the reflation trade was the eventual success the Fed had in convincing markets that a 46-year low in the Fed funds rate was unsustainable. March payrolls rising 308,000 helped in this effort to wean the market off its complacency on rates. So within a month markets learned rates would not remain lowi ndefinitely and deflation was successfully skirted, challenging two key assumption in the reflation trade.

So the paradox (wording problem) is as the global economy reflates, the reflation trade deflates (unwinds). Could it come back in favor? Surely as the long-run impact of Fed and G7 ultra-easy monetary policy is not yet known. In other words there is a risk of monetary policy overshooting on the downside and 70's style inflation is in the cards. But then again like most one-hit wonders this trade may never be heard from again.

Still the fact that the reflation trade was so popular in 2003 is a credit to the Fed itself which showed no hesitation in alerting markets to the risks of deflation (rarely seen) and subsequently made a case for negative real Fed funds, never raised a question over housing market mania/ballooning household debt and barely questioned record fiscal policy stimulus (tax and spending). Somehow the final chapter on this highly unusual period of economic policy mix has yet to be written. Greenspan is banking on "they lived happily ever after" but I am banking on a very challenging unwinding of a credit market bubble and a debunking of the Greenspan maestro mythology.

David Gilmore


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