With the rising inflation expectations and the surge in global bond yields, together with the overhang of higher domestic borrowings, how do you read the situation from the near- to medium-term perspective? Late 2020 has seen the commencement of the so-called reflation trade. It was first exhibited largely in the goods economy. As more and more parts of the economy started to open up, a lot of pent-up demand started to show up as well. And continuing on that theme, 2021 is probably the year of reopening and as the vaccination drive picks up, hopefully, we are able to flatten the virus curve and sections of the services economy will open. Alongside that, there is a general expectation especially in the developed world where people think that inflation will start to pick up, which will have two components. One is the base effect, because on a year-on-year basis, now you will see a significant jump in commodity prices, etc. The other is particularly related to the services economy as opening happens and pent-up demand is exhibited, so some bit of services-price inflation would also be observed. Importantly, there are two aspects here that one must keep in mind. One is the positioning of the large global central bank, let's say the U.S. Fed, where there is a consistent theme about patience. However, market expectations are now running quite strong with respect to the reflation trade. So, for example, we witness what's happening in the U.S. traded inflation. The market essentially believes that the inflation will come and remain at a higher level as compared to the last few years. However, the Fed, with a slightly standard view on inflation is fully willing to look through this one-shot readjustment on account of base effect and the one reset because of the opening of the services economy. Also, they don't see it to be a long-term problem as the markets think it is. Secondly, they are focused on getting the labour market back on track so that job distribution starts to get more equitable. So, global markets are pushing against the Fed's idea that the Fed could be more patient. To a diluted extent, this is what is happening in India as well where over the last couple of months, the rates markets have taken up the global reflation trade, even though the RBI is giving you guidance about continued provisions of liquidity and a relatively stable evolution of the yield curve. Our sense is that there is a difference between direction and the pace of repricing. The direction of the reflation trade is perfectly logical in the sense that as the economic activity picks up, monetary accommodation will have to be reduced. However, you can argue that the pace will have to settle down. Thus, if you observe, over the last couple of months, a large part of the reflation trade has played out. For instance, many commodities are up by 15-20 per cent and there has also been a significant jump in
This article was originally published on March 15, 2021.
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