USE THE FORCE: Morgan Stanley has a Star Wars-themed note out on the 'reflation' trade

Use the force, markets. Let go of your conscious self and trust your feelings. Global growth and inflation expectations are improving – that’s why global bond markets have been under pressure recently. The dark side of the force – global deflation fears – are being obliterated faster than a Death Star that’s taken a direct hit to its core reactor.

So says Morgan Stanley’s cross-asset research team, in a Star Wars themed research note released over the weekend, in which they believe that “reflation and growth have been the key drivers of higher bond yields seen in recent weeks”.

The team looks at the factors driving global reflation and summarises its investment case using these three summary dot points.

  • Inflation strikes back, as several indicators point to reflation
  • These (still) aren’t the yields you’re looking for, with bond prices remaining “unattractive”
  • Use the force – stay the course on reflation trade

Here’s Morgan’s view of what was the chief catalyst behind the sharp spike in yields of recent weeks.

“Investors the world over have spent the last month watching the plunge of Eurozone bond yields with disbelief, and the last week watching their reversal with amazement. On April 20th, the German government was able to borrow money for 30 years at a rate of 0.47%, the lowest rate in history of any major economy – as far as we can tell – at that time (and it was just two weeks ago), one heard a number of reasons why such extreme levels were entirely reasonable: The supply of these bonds was limited due to the scarcity of German borrowing. The ECB was actively buying Bunds, despite their yield. Inflation in the Eurozone remained subdued, making any return a good one, etc. Two weeks ago, however, that narrative started to be challenged. Sovereign and corporate issuers, responding to the (rather obvious) incentives that low yields provide, began issuing more long-dated bonds – YTD, we’ve already seen US$182bn of 30Y+ issuance from G10, the highest run-rate since our data began in 1980. Eurozone data, in line with our Economists’ forecasts, started to surprise on the upside in both credit growth and inflation. And, between April 20th and April 27, 10yr Bund yields backed up 9bp. It was a modest move compared to what came afterwards, but important. To the casual eye, 0.06% seemed it could be the trough in 10yr yields, on a chart going back forever. To a host of investors who had been trying to short the EU market (successfully or not), a window seemed to have presented itself. And to computer-driven funds, which are often trend-following — and by our estimates had had a good run in the Eurozone bond market — it flagged the beginning of the end of the trend of ever-lower yields”.

According to Morgan’s a sharp increase in longer-dated issuance, accompanied by improved Eurozone data, led to the sharp increase in bond yields. This, rather than changes to the expected timing of the Federal Reserve’s first rate hike, liquidation of Eurozone assets or alterations to buying patterns as part of the ECB’s quantitative easing program, explain the sudden move.

Looking at the sharp lift in inflation expectations in both the US and Eurozone in recent weeks, it appears that many in the markets believe the rise in global growth and inflation expectations will not be transitory in nature.

Morgan’s investment strategy certainly backs this view.

Despite the big moves across markets, we believe that staying the course on reflation trades makes sense. In Equities, we continue to like Financials and Energy globally. The former should benefit from higher rates environment, and the latter should go higher as growth recovers. We maintain our underweight in Government Bonds in our cross-asset allocation, believing that growth and reflation should lead yields higher and curves steeper from where they are now, especially in Europe, even after the move.

Will the Empire of deflation “strike back” or is this truly the return of the reflation trade?

Morgan, sounding as wise in the ways of the force as Obi-wan Kenobi, certainly believes so. They end the note with this: “Reflation is strong, and returning. May that force be with you.”

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.