Dovish Fed sparks Asia risk rally

As the inflation narrative has pushed to the forefront of financial markets and headline indices volatility has picked up in equities and there have been several pivotal realisations. Namely that inflation is already here, and a consensus is now building around the transitory (or not) nature of this inflation. Causing many to reassess the timing of central banks taper discussions, alongside positioning portfolios for higher inflation.

Price action has been dominated by deleveraging in US equities as many reassessed inflation outlooks and some were still offsides with reflationary positioning with the S&P 500 recording its first 2 consecutive weeks of losses since February. The volatility fuelled by an element of complacency following a prior sequential string of ATHs throughout April. However, from a cross asset perspective spill over was limited, and volatility has now retraced significantly, indicating that the cyclical rotation likely has further to run as positioning is grossed up with both volatility and the dollar declining. And as yields resume their climb. Not the time to ditch reflation trades yet. Europe a beneficiary here within the continued cyclical rotation as the incoming data suggests the rebound is gathering steam and set to surpass the US as the reopening takes hold in the month ahead. Real economy stocks and cyclical sectors benefitting as earnings accelerate alongside the reopening and macroeconomic recovery. More attractive starting valuations, and increased leverage to the strengthening economy and recovery period an advantage - Inflationary pressures and pick up in yields are supportive for real economy stocks and cyclicals. The outperformance of long duration growth challenged by higher inflation expectations, crowded positioning, hefty pandemic induced comparisons and an ongoing rotation as portfolios pivot toward inflation.

This week risk sentiment has begun on a more even keel, helped along by various Fed officials downplaying the inflation narrative and continuing to point to these emergent price pressures as transitory. In a quiet trading session in Asia, risk assets have remained buoyant, and the dollar has continued its decline with USDCNH briefly touching the 6.40 level.

Commodities are rallying in tandem with dollar weakness following last week’s retracement and commentary from China that has weighed on the space in recent sessions. Continued strength in commodity markets feeding through to producer prices, higher input costs and across soft commodities higher food prices continuing to perpetuate the growing consensus that price pressures may not be so transitory (whether this manifests in manipulated CPI indices is another debate all together). Supply shortfalls, alongside soaring vaccine led demand rebounds, green transformation spending (electric vehicles, smart electricity grid building and renewable power generation), spending on infrastructure, and a weaker dollar continue to signal that commodities still have further to run.

For the last month US 10yr treasury yields have stagnated, remaining rangebound, stuck around the 1.60 level. We continue to expect higher bond yields, last months miss on the US jobs report unlikely to be repeated this month as the reopening continues and estimates cluster around the prior miss – highlighting the non-linearity of recovery trajectories. Several states will end the additional $300/week unemployment benefits from mid-June promoting return to the workforce, in addition school reopenings continue also promoting increased return to work and supporting the notion that overall trajectory is clear toward restoring the labour market at an increasing pace.

As the pace of the economic rebound peaks and slack subsides, focus will begin to shift to the impact of higher inflation, rising input costs, margin pressures and the prospect of potential tax hikes/tapering – likely a more difficult period to navigate is approaching in the 2^nd half of this year with more volatility to be expected. Any taper talk or shift toward Jackson Hole providing an inflection point for policy becoming a game changer for reflationary positioning.