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Weekly Focus – Reflation Trades Take a Break

Despite more very strong data this week, reflation trades took a break this week. US and euro area bond yields drifted lower this week and stock markets moved sideways. Commodity prices retreated with oil and copper prices drifting lower and iron ore prices taking a big dive. Inflation expectations in the bond market also fell back in both the US and the euro area. It seems investors are very much positioned for the reflation theme already making it hard for markets to go much further for now. In the medium term we still look for higher bond yields once the recovery gets to the stage where the service sector becomes the driver of growth and job creation picks up, see also Yield Outlook: Inflation = higher rates and yields, 11 May 2021. We are still constructive on equity markets, although returns may be lower from here given higher valuations a peak in the cycle in H2.

This week we published another piece in our inflation series: Global Research – The impact on inflation of a commodity super cycle, 25 May 2021. We look at three scenarios for commodity prices and what it means for headline inflation in the US and the euro area. In our baseline scenario, US inflation peaked in May while euro inflation does not top out until September. In this scenario, the rise in inflation is transitory. In a ‘commodity super cycle’ scenario, the rise in G2 inflation is more sustained and stays above 3% in 2022.

Both the the Fed and ECB continue to signal patience when it comes to tapering bond purchases. At Danske Bank’s Nordic Summit this week ECB member Francois Villeroy stroke a dovish tone saying “let me be crystal-clear: any hypothesis of a reduction of purchases partly for the third quarter or the following quarters is purely speculative“. Federal Reserve member Randal Quarles laid out a case on Wednesday on why upside risks to inflation were mounting but he underlined that “I don’t want to overstate my concern“.

When it comes to the global economy, the data continues to be strong. US PMI for both manufacturing and service hit new record highs (data goes back to 2010) and the German ifo expectations index rose further. Euro area consumer confidence has also seen a sharp lift in May to the highest level since the upturn in 2018. US consumer confidence fell slightly in May, though, but the “jobs plentiful” index is back to the high levels seen before the COVID crisis broke out. It confirms that the main barrier for job growth in the US right now is not the availability of jobs but rather that some people still refrain from taking a job. However, when the extended benefits expire in September and the vaccine roll-out is complete in the coming months, we expect more people to take on available jobs.

Looking into next week, we have US ISM as well as non-farm payrolls.  After the disappointing job number of 266k in April, expectations are a bit more moderate this time with consensus looking for 620k (rather than the 1 million estimate last month). ISM manufacturing is expected to stay broadly unchanged at the current very high level. PMI’s are also due in China, where we look for an increase on the back of strong exports of goods to the US following the big stimulus in Q1. Euro area flash HICP for May out Tuesday: we expect a further increase in headline inflation, jumping above the 2% threshold for the first time since October 2018. Much of the increase is still driven by energy base effects, but we also look for a slight recovery in core inflation to 1.0% on the back of firming service prices.

Full report in PDF.