In a twist of events, the so-called reflation trade, which has been a dominant market theme following an unexpected inflation surge, appears to be losing momentum. Despite the recent rise in oil prices and consumer demand, experts warn that this trend may not persist, urging investors to exercise caution.
The reflation trade, typically observed when oil prices rise due to increased economic demand, has been a notable market reaction to the inflation surge. The consumer price index (CPI) for July and August registered a growth of just over 3%, surpassing expectations. This came as a surprise to many, especially given the Federal Reserve's rate hikes over the past year aimed at curbing demand.
In line with this robust demand, oil prices have also seen an uptick. West Texas Intermediate (WTI) crude recorded an approximately 17% increase since mid-August, reaching $91 per barrel. This surge led to about a 6% gain for the Energy Select Sector SPDR ETF (NYSE:XLE), an exchange-traded fund for oil stocks, outperforming the S&P 500's 2% gain.
Long-term bond yields have followed suit, with the yield on 10-year Treasury bonds rising from around 4% in August to 4.35%. This has led to an appreciation of the dollar's value as higher U.S. yields make American fixed-income assets more appealing to global investors. As a result, the U.S. Dollar Index (DXY) climbed from an August low of 102 to 105.
However, experts warn that these market movements may have already reached their peak and that it would be imprudent for investors to expect the reflation trade trend to continue indefinitely. The Federal Reserve indicated during its annual Jackson Hole Economic Symposium in August that the impact of higher rates on economic demand often takes time to materialize and could continue to decline. This expectation is reflected in the 10-year break-even rate, which indicates the bond market's projected average annual inflation for the next decade, having dropped from an August peak of 2.41% to roughly 2.35%.
This anticipated decline in demand suggests that oil prices may have already peaked. The last time WTI crude reached this level was in October 2022, after which sellers drove the price down. Currently, WTI crude is not surpassing $91. Similarly, the oil stock ETF, priced in the low 90s per share, has been consistently driven down by sellers since 2014.
The dollar's value may have also reached its zenith. Each time it has touched its current level since November 2022, it has subsequently dropped. It was slightly down on Monday.
Given these market trends, it appears that the reflation trade may have already run its course. As such, investing in bonds instead of other assets could be a prudent strategy. Investors have the opportunity to secure current yields before they decrease. The 10-year yield currently offers almost two percentage points more than the expected annual inflation for the next decade, potentially serving as a robust hedge against risks in the stock or oil markets.
This article was generated with the support of AI and reviewed by an editor. For more information see our T&C.