Why Are Markets Talking About 'Reflation Trade'? Here's What Investors Need To Know

Despite the turmoil in Capitol Hill, the markets kept going up. While this may seem irrational, markets are forward-looking and are betting on "Reflation trade."

What Is Reflation Trade: Reflation is an economic concept of price growth, stimulated by fiscal or monetary policy, to curb the effects of deflation during a recession.

When Congress certified Joe Biden's Presidency and Democrat control of the House and the Senate, investors cheered as the Democrats will be able to push their agenda without political gridlock. 

The market anticipates that Joe Biden would continue with the loose monetary policy, keeping interest rates lower for longer to induce growth. Moreover, Biden is expected to deliver a fresh stimulus package, a significant part of which could directly go as checks to American households.

What Assets Work In Reflation: When economies go into recession, fiscal spending comes into play to avoid sinking growth.

Cyclical sectors, such as banks and energy, are directly impacted by fiscal spending. In the current environment, sectors affected by COVID-19 like restaurants, airlines, theaters, and cruise operators stand to benefit from the pent-up consumer demand.

Relation Signals: Despite the interest rates being at historical lows, the Ten-year Treasury bond yields have risen above the 1% mark in the last week. The Ten-year Treasury yield is up by 1.9 basis points to 1.09% at publication time, while the 30-year Treasury yield is at 1.859%.

The small difference between the medium and long-term bond yields signal that investors are betting that asset prices will rise in the short-term.

Commodities: The economy is not back on track, and yet the commodities prices are going up. Copper, which is a well-known growth barometer, is near an eight-year high, with almost 31% growth since October. 

The oil prices have also grown 44% since October lows. Though Saudi Arabia cutting the crude oil output a few days ago in a surprise announcement led to a jump in oil price, investors have been betting on the commodity since November.

Higher inflation expectations may boost alternative assets like Bitcoin, which is trading near all-time highs as the market is flush with liquidity.

The Vaccine Factor: Even as the world deals with rising COVID-19 cases in many countries, a combination of vaccine rollout and fiscal policy has led to investor optimism, leading to reflation.

Risks: Markets are forward-looking, and it has priced that the pandemic will end soon. If there's a delay in vaccine rollout or the number of infections rise, the pandemic could take longer than anticipated to end. Moreover, if governments cut back on fiscal spending, then the optimistic scenario won't play out.