Fed's hawkish turn shakes up markets, but investors say reflation trade lives on

A hawkish turn by the Federal Reserve has jolted the reflation trade in equity, bond and commodity markets, and while the run may not be over, its most profitable period may be.

"The easiest money has been made," said Paul Schatz, president of investment management firm Heritage Capital, in an interview. "The first leg of the trade is over."

This reflation trade, which occurred as the money supply increased and the U.S. economy moved toward a post-pandemic recovery, involves investors betting on a return of inflation spurred by massive stimulus spending under a Joe Biden presidency and Democratic Congress. It has caused cyclically-sensitive stocks to outperform defensive ones and value-based buys to beat growth shares, along with a rally in commodity prices and rising long bond yields.

But after the Federal Reserve's latest quarterly forecast on June 16 indicated the potential for earlier-than-expected rate hikes, the momentum for value over growth stalled, short-term government bond yields surged and value and cyclical stocks plunged. Despite a majority of Fed officials moving up their forecasts for the timing of the next rate hikes, the Fed's ultraloose monetary policy, including an ongoing commitment to near-0% rates and monthly purchases of $120 billion in treasuries and mortgage-backed securities, remain in place.

"The aftermath of last week's [Federal Open Markets Committee] meeting has dealt another blow to the already-flagging [reflation] trade in the U.S. stock market, but we doubt that it is entirely dead and buried," said Oliver Jones, a senior markets economist with Capital Economics in a June 21 note.

Long-maligned value stocks — which tend to have low price-to-earnings ratios, but solid fundamentals — have climbed as much as 17.4% since the start of 2021, as the reflation trade took root while vaccination numbers climbed and COVID-19 deaths dropped. Those stocks dipped roughly 3.8% following the Fed meeting.

Meanwhile, the tech-heavy growth stocks, which had rallied during the height of the pandemic but were outperformed by value stocks through the majority of this year, rallied about 1.7% after the Fed's forecast was released.

The reflation trade has also been a boon to cyclical stocks, particularly the consumer discretionary, industrials, materials, financial and energy sectors, which saw an average increase of 22.1% since the start of this year. Cyclical stocks tend to perform better during a booming economy and worse during a declining one.

By comparison, defensive stocks, including utilities, consumer staples and healthcare, have increased just under 5% so far this year. Defensive stocks tend to provide stable earnings and dividends even when an economy is in decline.

The strength of cyclicals, however, has been tested by the Fed's potential early push for higher rates. For example, the S&P 500's energy sector, which has climbed nearly 44% since the start of the year, plunged about 6.7% after the Fed meeting. Financial stocks, which climbed as much as 30% from the start of 2021, dipped 5.4% after the Fed meeting.

Schatz said the Fed's hawkish turn likely sparked a short-term reversal back to growth and mega-cap stocks, but said the rotation may already be reversing.

"I still believe that cyclical sector stocks are the place to be," Schatz said.

Small cap stocks, which tend to perform better during economic recoveries, have outperformed their large-cap peers. The small-cap Russell 2000 index is up about 16.6% on the year, compared to 12.9% for the large-cap S&P 500. But the Russell was also hit by the perceived shift in Fed policy, dropping roughly 3.5% in the days after the meeting.

Treasury yields

The Fed meeting resulted in a jump in short-term U.S. Treasury yields, pushing the five-year yield initially up 10 basis points, from a close of 0.79% on June 15 to a settlement of 0.89% on June 16. The 30-year yield, by comparison, was unchanged at 2.2% over that time.

Following the Fed meeting, the gaps between long and short-term bond yields tumbled. The gap between the 30-year yield and the five-year yield fell 29 basis points to 112 basis points, while the difference between the 10-year and two-year yields fell 16 basis points to 119 basis points. This flattening in the yield curve tends to signal tighter monetary policy.

But yields lately have betrayed conventional thinking.

Since the start of June, the benchmark Treasury 10-year yield has fallen 14 basis points despite the hawkish turn from the Fed and historically high inflation forecasts, which normally would trigger a rise in yields.

"These are not normal times," said Tom Essaye, a trader and founder of financial research firm The Sevens Report in a June 23 note.

The decline in yields is likely a result of technical trading and momentum rather than a reaction to the economic recovery, Essaye wrote. The moves in yield have far more to do with liquidity and the record-high global money supply.

"The world is so stuffed with cash that it must find a home, and U.S. Treasuries remain one of the few assets that can absorb the amount of cash floating around the globe," Essaye wrote.