US: The case for reflation – Danske Bank

Research Team at Danske Bank, suggests that following the election of Donald Trump as US president, the reflation theme has gained extra fuel.

Key Quotes

“Industrial commodity prices soared adding to the gains already seen this year. In addition, US market inflation expectations got a big lift. We – and others – have cried wolf over the past couple of years in terms of rising inflation but it did not happen. However, one day it will, and the question is whether that time is now. Based on commodity prices it is almost certain that so-called base effects will push up inflation over the next six months. However, this will only be temporary unless commodity prices continue to trend higher in coming years. Real reflation is a sustained rise in inflation in which the economy is running hot, pushing wage inflation higher as well.” 

“We see a good case for reflation in the US whereas it will take more time for the euro area to join. The euro area has more slack left, still many growth headwinds and no signs of wage inflation picking up. In contrast, the US has more or less closed the output gap and it is likely that the economy will run hot over the next year – not least when the expected fiscal stimulus from Trump sets in at a time when we expect unemployment to be below NAIRU (long-term equilibrium level) and wage pressures have increased.”

“The investment conclusion of reflation in the US is higher bond yields, a stronger USD, higher stock prices and rising inflation expectations. We look for US 10-year yields to hit 3% (currently 2.31%) in 12M. We expect a stronger USD in six months but weakening from six to 12 months, as the main impact of US reflation is likely to be felt over the next six months.”

“We see a good case for reflation to play out. This would, in our view, play out even without Trump’s fiscal expansion. However, his policies are likely to add to the reflation case for the US.”

“Could a USD appreciation stop the fun? It is not likely, in our view, as tempering a too strong USD is part of the reason why the Fed will move very gradually and only raise rates twice in 2017. If the USD strengthened too much, the Fed would simply hold back on rate hikes to allow the economy to run a bit hot and a possible overshooting of the inflation target.”