Reflation, reflation, reflation – can’t keep saying it enough it will be the theme of the year. It’s clearly building fast and there is growing evident that what’s happening in the bond market right now will filter into equities which is a risk we need to discuss.
As I mentioned last week you know you are in the throes of a bond market bear phase when Japanese Government Bonds (JGBs) are participating in the selloff – a trend that has only accelerated in the past week.
What is more interesting is the speed of sell off – here is the Aussie 10-year bond, the US 10-year bond and the spread between them over the past 11 months. It is off to the moon appreciation – some are even suggesting we are witnessing the new 1994 bond market crash.
If we then look at the chart comparing the Aussie-US 10 year spread to the AUD/USD the directional flows are also very apparent.
However, like we stated last week we know from previous bond market sell off is it’s not linear. We need to point to this first as what is also likely to happen from this bear market movement is it will spread to other markets, particularly interest rate sensitive one like equities and property. The fall in global equity markets at the backend of last week is case in point and is a risk to the ‘FX flow trade’ we are currently following, watch for pressure on the likes of the AUD, GBP and EUR.
We also know from previous bond market sell offs that fixed income investors jump from one international market to the next looking for risk free rewards.
We had suggested being neutral USD and look to widening spreads against US bonds to trade. This proved correct as the AUD/USD to 10 v 10 spread chart shows. However, we do need to point out that there are some short-term risks here as risk markets and economies price in possible sell offs. Do not be surprised if the USD has a solid week as risk currencies follow their respective equity markets, again watch G10 risk currencies in the interim.
But – the theme of reflation is strong and with central banks continuing to state publicly that they are unmoved by the possible inflation threats in the near term the flow trade looks set to remain attractive over the coming months.