FOR SEVEN months most investors have been singing the same uplifting song. Since Pfizer and BioNTech published the successful results of trials of their covid-19 vaccine last November, the way to make money in markets has been to bet on a roaring rebound in the global economy, as pent-up demand for all the things the pandemic denied people—holidays, dining out, shopping—was unleashed. This “reflation” trade lifted the prices of commodities used in construction, such as copper and lumber, to record heights. It lifted global stocks, especially the share prices of firms hardest hit by the pandemic, such as cruise operators and retailers. The currencies of emerging economies, which tend to benefit more than most from global economic strength, rallied against the dollar and the euro. Bond yields climbed along with expectations of speedy growth and higher inflation.
But that changed on June 16th, after the Federal Reserve—hitherto apparently sanguine about rising American inflation—suggested that it may eventually think about raising its policy rate, long anchored at zero. Shorter-dated bonds and shares tumbled, as did those building-boom commodities. After a jittery week, some investors may start this one wondering whether they over-reacted.
The enthusiasm of the past few months was underpinned partly by the assumption that the Fed would maintain the same, super-loose monetary policy. Hence the anxiety when Jerome Powell, the Fed’s chairman (pictured), suggested that the central bank might have to consider tightening “somewhat sooner than previously anticipated”. The Fed raised its inflation forecasts and lifted its median estimate for the future of policy rates to include two increases in 2023. Mr Powell also said the Fed would begin discussing when to slow its asset purchases from the current $120bn per month. Any doubt about the change of tone was snuffed out two days later when James Bullard, head of the St Louis Fed, told CNBC that the first rate rise could arrive in late 2022.
The Fed had seemed nonchalant even as signs of overheating in the American economy became harder to ignore. The central bank’s target measure of inflation, “core PCE”, jumped to 3%, year on year, at the end of April. Headline inflation, gauged by the consumer-price index, has climbed from less than 2% in February to 5% in May. Anecdotal evidence of overheating abounds, from the piping-hot housing market to spiking grocery bills, gas prices and Uber fares. Yet Fed officials said the acceleration in inflation was “transitory” and that they would look through its effects. Investors believed them.
They were accordingly surprised by the change of tone. Many of the trends that have dominated markets since November unwound. Reflecting the prospective rate increases, the yield on two-year Treasury bonds jumped to 0.27%, from 0.16% on June 14th (see chart). The 30-year yield, which tends to follow long-term growth or inflation expectations, tumbled to 2.02% on June 18th, from 2.21% before the Fed’s meeting.
The prospect of the Fed putting a brake on inflation and growth hit share and commodity prices. The S&P 500 slipped from near a record high, ending the week about 2% lower. “Value” stocks, which had performed particularly well since November, were hard hit. Copper lost its spark, shedding 8% over the week. Lumber was felled, dropping 15%.
The Fed also wrong-footed monetary policymakers elsewhere, several of whom met after the Fed did or are due to convene this week. When the Fed last unwound a post-crisis stimulus, in 2013, setting off a notorious “taper tantrum”, many emerging-market currencies, notably those of Brazil, India, Indonesia, South Africa and Turkey, fell sharply against the dollar. On June 16th the Brazilian central bank raised its interest rates from 3.5% to 4.25%, the third increase since February, despite the damage covid-19 has done to Brazil’s economy (and to Brazilians’ health). The currencies of the other four countries have fallen by between 1% and 4% against the dollar since the Fed’s meeting. An index of the dollar against other leading currencies rose by 1.9% last week.
As a new week begins, investors will ask whether the shift signalled by the Fed warranted such strong reactions. It is possible that markets overdid it. When many investors hold the same portfolio of positions, they can be forced to bail out in a hurry if markets move violently against them. This liquidation of positions can exacerbate volatility. In fact, there are reasons to think the great reflation trade has further to run: the full reopening of the American economy is still in its early stages and the end of 2022 is a long way off.
But those turning their backs on emerging-market currencies, value stocks and copper will find plenty to convince them that a new phase for markets and the economy has already begun. Lumber prices were already slipping before the Fed meeting, as a frenzy for home improvements cooled. Credit-card spending, an early indicator of economic activity, has been running 20% higher than it was two years ago, but this month the pace has slowed to 16.5%, according to Bank of America.
Soon, investors will learn which bet pays off next. But those still eager, after last Wednesday’s surprise, for hints of what the Fed thinks is in store are in luck. Its officials, including Mr Bullard and Mr Powell, will make no fewer than 12 public appearances this week.