There Are Three Things That Can Kill The “Perfect Reflation Trade”: Lessons From Two World Wars

By Michael Every of Rabobank

Merry Christmas, War is Over(?) – A strategic/tactical view of the reflation trade

“So this is Christmas; And what have you done?
Another year over; And a new one just begun
And so this is Christmas; I hope you have fun
The near and the dear one; The old and the young
A very Merry Christmas; And a happy New Year
Let’s hope it’s a good one; Without any fear.”

–  John Lennon ‘Merry Christmas, War is Over


  • The markets are crying out that ‘War is Over’ this Christmas, and pricing for a perfect reflation without any tears

  • History after real wars shows that this confidence is likely to be misplaced unless politicians have really learned their fiscal lessons

  • Tactically, however, we suspect there could be misplaced market fears of inflation in H1 2021

  • Indeed, risk assets can arguably outperform in 2021 unless three key, linked risks are triggered: tighter monetary policy, a swing up in the USD, or too-tight fiscal policy

V for Victory and for Vaccine

At the start of 2020 we flagged a devastating global economic impact from Covid-19, if Europe and the US weren’t able to avoid the virus already spreading in Asia. Most of what we feared would occur then occurred: rolling on/off lockdowns, huge voluntary and involuntary restrictions on normal life, a collapse in services and travel, and massive supply-chain shocks.

This was inevitably going to require massive stimulus, and monetary policy alone wouldn’t suffice in the face of such tectonic supply and demand shock. It was clear government support would be required, and would push fiscal deficits to levels last seen during WW2.

Moreover, our suspicions that this spending would end up being de facto financed by central banks were also confirmed: extraordinary monetary policy was rolled out or expanded across both developed and developing economies. QE, and even open debt monetization, have become ‘normal’ even in economies one would never have expected, such as Poland and Indonesia.

Yet even as both lockdowns and the virus continue to rage in many countries, victory may be in sight.

We have not just one but multiple successful vaccines being rolled out that present the very real possibility of things ‘getting back to normal’ ahead. Indeed, the first member of the public, a 90-year old British lady, was injected with the vaccine on 8 December. Billions will hopefully follow.

Without any fear, for sure

Good spirits had already emerged after what looks (barring an unexpected “contested” election) to be US President Biden from 20 January; despite President Trump’s pro-business and pro-market policies, there appears a sense of market relief at the prospect of a more conventional personality in the White House, at least in terms of trade/geopolitics.

This was even more the case coupled with no Democratic majority emerging in the Senate rather than a ‘Blue Wave’: regardless of who wins the two Georgia senatorial run-offs on 5 January, Democratic control could only come via the deciding vote of the Vice-President, assumed to limit the policy room for manoeuvre for Biden and ensuring policy has to be relatively ‘consensus’.

‘War is Over’

Yet since the announcement of Covid-19 vaccines, markets have been trading as if ‘War is Over’ and a global peace-time boom here. As this Moneyweek front cover states “Prepare your portfolio for a return of the Roaring ’20s”, and indeed:

  • Risk is very much ‘on’;
  • US equity markets continue to reach new record highs;
  • 10-year US Treasury yields have risen to test near 1%;
  • US inflation expectations are up;
  • The USD has fallen against most major FX crosses;
  • Most key commodity prices have jumped; and
  • Net inflows to emerging markets have soared.

Yet is a “reflation” trade really justified? Our Rates Strategy team’s view of global financialisation continues to argue “No”. In fact, there is an argument to be made that under Covid-19 we have seen years of financialisation condensed into 10 months, with the rich/asset-holders getting far richer and the poor/many workers seeing life become more precarious.

Rather than re-exploring that theme here, we wish to examine how economic recoveries from actual wars have looked. To do so we need to focus on countries with histories of war and key data: we will use the US and UK. And rather than an in-depth analysis of how quickly or completely the US and UK economies will be able to bounce back from Covid-19, we want to look at how well both recovered in the immediate aftermath of both WW1 and WW2.

This could be the subject for an entire thesis, but what we want to do is focus on GDP, inflation, and bond yields as a proxy for how rapidly things returned ‘to normal’ – because that is what the market is telling us is about to happen again in 2021 now that the Covid-19 ‘War is over’. What does real post-war history show us?


The damage wrought by Covid-19 has been extraordinary. In the US, total loss of life has already exceeded all the military deaths recorded in WW1, and may be above those of WW2 before the end in a worst-case scenario. Compared to the total population, Covid-19 deaths are likely to be around the WW1 level of 0.1% and far below the 0.4% seen in WW2.

True, the majority of these Covid deaths were of the old and sick not the young and healthy, as in WW1 and WW2. Yet this fails to consider ongoing healthcare costs for many survivors, as Covid-19 can result in many permanent debilitating symptoms – not that WW1 and WW2 did not leave a vast number of young injured, of course.

In the UK, total Covid deaths also represent around 0.1% of the population. However, this is far less than the 895,000 who were killed in WW1, equal to a staggering 2.1% of the 1918 population, and the 450,000 who died in WW2, equal to 1.0%. As can be seen, the UK suffered far more in both wars than the US. Again, there will also be ongoing healthcare costs to bear for many survivors, of course, but less than after the two World Wars.

In short, Covid-19 was on the relative scale of WW1 in the US, but was far smaller in the UK, and compared to WW2 in both.


Despite often being dubbed ‘a war’, the quandary of battling Covid-19 is that it requires restraint in economic activity, albeit mostly in services rather than the goods sector.

In the US, GDP shrank by a record amount in Q2 2020 before rebounding by another record in Q3, but with new lockdowns in Q4 it is likely to end the year with a significant recession; the long-term damage and loss of swathes of small businesses and service-sector jobs is still being tallied. The UK’s Covid-19 recession was still the deepest for 300 years, and the ongoing structural damage to GDP is likely to be similar to that in the US.

By contrast, WW1 and even more so WW2 saw US production increase massively. The shift to a war economy and vast government military spending was highly stimulatory, and had key spill over effects in many industrial and technological sectors.
The US also suffered no damage at all to its capital stock given its benign geographic position. It emerged a global superpower, with its post-war debt large but domestically held. (Please see here for a look at the long-run trend in public debt in key economies and how it was dealt with.)

WW1 and WW2 also saw the UK shift to a war economy, and an initial surge in GDP growth rates as private-sector businesses were co-opted for the war effort. Output was maximized despite domestic consumption being constrained via rationing.

Notably, the UK still exited both wars in a greatly weakened economic condition, with damaged infrastructure and a loss of both housing and capital stock. It also had enormous public and external debt to service.

* * *

US: post-war post-partum

So that’s the backdrop: what about the post-war recovery?

After WW1, the US did not see a boom but a bust. Over 1919-21 there was a nasty recession as the government rolled back spending and the private sector failed to fill that gap. After WW2 a similar pattern emerged: initially there was a sharp slump as huge public spending into war industries was reversed. Indeed, GDP did not start to pick up strongly until around 1950. There was actually a five year gap before the so-called post-WW2 boom kicked in.

Likewise, US CPI of 20% y/y in WW1 due to a squeeze on key resources was not followed by post-war inflation. Aside from a brief spike in early 1920, the US actually recorded deflation, then low inflation. The ‘Roaring 20s’ did not see CPI roar – and a large part of this was due to the deflationary straitjacket of the gold standard of that time.

After WW2, inflation was also initially low apart from a one-off jump in 1947 as price and wage controls that had been in place since 1942 were unwound. Once that adjustment had taken place, however, inflation remained constrained until the growth of the 1950s kicked in years later.

In terms of US 10-year Treasury yields, there was no post-WW1 spike either. In an environment of global deflation and then low inflation, this should not be a surprise.

Indeed, the 1920s was a decade in which unpayable wartime debts (owed to the US by the UK and France, and to the UK and France by Germany, which Germany was unable to pay, but instead borrowed again from the US) were reshuffled rather than resolved. This eventually ended in the 1929 Wall Street Crash and the political extremism of the 1930s, then war. During this entire time US Treasury yields drifted lower.

During WW2, US Treasury yields were capped by the Fed, with this ‘yield curve control’ used to help finance the war effort. (As we have noted before, this policy is not new.) Even after WW2, US yields still remained capped to help pay off wartime debts via continued financial repression. Would one really want to have been holding a 10-year US Treasury at around 2.4% when inflation was spiking to 19.5%? Markets had no choice, however.

In short, in the US we have a story of immediate post-war slumps, not booms; of post-war deflation for the most part, except where government controls were removed; and post-war stability in bond yields due to government controls.

The feel-good growth did not begin in earnest until 1950, a full five years after the iconic picture of a sailor kissing a girl in Times Square. That is *five* full Christmases, something for the markets to ponder as we head into this one so optimistic.

It was logical, however, given the US saw government spending slump from such high levels: how could the private sector fill that gap?

* * *

UK: Post-haste decline

In the UK, which had seen far more physical damage in WW1 and had fought for far longer, the post-war economic recovery was mixed.

The private-sector initially enjoyed a boom as investment picked up and the key shipbuilding industry in particular replaced lost merchant shipping stock. However, government spending contracted rapidly, and post-war recessions in other countries dragged down export-dependent UK industry. The economy slipped back into a serious recession over 1921–1922: the gold standard ensured it stayed there for most of the decade.

Following WW2, there was again a recession due to the cut in huge wartime spending and then the sudden withdrawal of US Lend-Lease support in September 1945: a US loan in July 1946 was needed to restore economy stability. From 1946-48 the UK saw bread rationing, which was not necessary during the war. Indeed, it was 1947 before UK GDP growth started again as public investment kicked in. That was two long, cold Christmases.

The post-WW1 environment was also deflationary, not inflationary – and it stayed that way for the next decade. Again, thank the prevailing gold standard from 1925 onwards at the too-high pre-war exchange rate, a peg which was only dropped again in 1931. For obvious reasons the same period was also one of increased unionisation and union militancy in the UK.

Post-WW2, inflation pressures were notably higher, and in advance of a pick-up in growth, due to shattered supply chains and a much stronger labour movement, but initially stagflationary not reflationary.

In markets, post-WW1 UK gilt yields saw a moderate decline from a 1920 peak of 5.32% to hold at 4.3-4.5% for most of the decade, with BoE rates high to keep sterling on gold. Given deflation, this meant very high real rates – and so hardly the stuff of end-of-war good spirits.

Post-WW2, the BoE meanwhile kept base rates at the low of 2% prevailing for the whole of the war, indeed right up until late 1951; gilt yields only picked up from 2.76% to around 3.5%, which given higher inflation overall meant real yields were low or negative.

In short, the UK saw a painful post-WW1 victory due to an inappropriate fiscal, monetary and exchange rate policy and a challenging global environment on top of massive war debts and loss of young men. After a rocky start due to external vulnerabilities, it saw a happier recovery post-WW2 due to looser monetary and fiscal policy, a more appropriate exchange rate, and a benign global backdrop once the US Marshal Plan was introduced.

The key lessons from the US and the UK should be obvious: post-war ‘victory’ does not always look or feel like victory at all. It depends on: 1) the starting position; 2) monetary policy; 3) fiscal policy; 4) exchange-rate policy; and 5) global demand.

Markets need to carefully consider these factors if they want to be sure they are right to be so upbeat about the war being over.

* * *

Awful Austerity Again?

1) Starting base

In which regard, the 2021 starting base is good in that we don’t have excess wartime production, except perhaps of ventilators (or office space). Rather we have suppressed supply and demand that can come back online as the virus situation allows.

However, permanent economic damage will have been done. There are (very) early estimates that up to 48% of US small businesses may never reopen, and structural unemployment may push much higher. Indeed, office-focused cities and tourism-based locations may never recover fully – and should they even aim to? After all, following the Covid-19 virus ‘war’ there will inevitably be another at some point. War is never really over. Does it make sense to return to an economic model primed for disruption by events that are no longer black swans? Or to one that has been structurally “disrupted”?

2) Monetary policy

Meanwhile, monetary policy is arguably close to its useful limit, with nominal rates trapped around zero or just below in most major economies. QE is now a standard policy tool, with significant room for expansion in some major economies: yet it also faces declining returns, and does not provide a solution for real economy problems.

3) Fiscal policy

So what of fiscal policy: is it going to help or hurt? Arguably the latter! True, we have arguably crossed the Rubicon to Modern Monetary Theory (MMT), as we had suspected would have to occur in 2020. Look at central bank balance sheets and their QE and government bond issuance. Is any of this massive “asset-swap” really going to be unwound ahead?

Yet the traditional economic advisors around governments are not embracing this fact. Rather, as after every war, there are already signs that more traditional fiscal and economic thinking is going to try to reassert itself.

“Belt tightening”, “dealing with the debt”, or “balancing the books” is the message – not that most extraordinary state spending due to the virus has been de facto covered by central bank debt monetisation, just as it is during a real war!

Almost certainly, fiscal deficits as a % of GDP will be much smaller in 2021 than they were in 2020: and as the government pulls money out of the economy on a net basis, is the private sector ready to put more than that *in*?

Will they have confidence and output automatically ‘bounce back’ as neoclassical economic theory assumes? Or will a lower net flow of public spending, or even just public spending lower than is required to boost confidence, prevent that bounce from happening?

Both WW1 and WW2, as well as the 2008 crisis, show the risks of reducing fiscal stimulus too soon. Doing so would mean a post-war hangover, not a post-war party awaits.

4) Exchange rate policy

The USD is down markedly against most major crosses, which is seen as pro-growth and risk-on. Yet consider this also means emerging market exporters, especially in Asia, are seeing a rise in deflationary pressures and a hit to export earnings on top of the evaporation of tourism-driven FX inflows. This does nothing to drive growth there given their economies are not primarily consumption-driven.

Indeed globally, almost nobody wants a stronger currency. Europe doesn’t; China doesn’t; Japan doesn’t; the UK doesn’t; and neither Australia nor Canada nor New Zealand do. Only a few emerging markets would arguably benefit from FX stability or appreciation – but even then only the ones who can look to domestic demand for growth.

5) Global demand

Beyond the base-effects bounce of 2021, which economy can truly say that it has brighter prospects post-Covid than it did pre-Covid? And to what extent is that economy able to lift others around it? Who is going to be doing the economic heavy lifting?

Not the US, apparently, despite the return to a US consumer of last resort vis-à-vis Asia during the Covid crisis. Not Europe. Not Japan. Not the UK. Meanwhile, China is openly talking about ‘dual circulation’, which will ensure that more of what Chinese growth there is stays in China via lower reliance on imports.

We already saw pre-Covid that a process of deglobalisation and regionalisation had begun: even under a US Biden administration, this can arguably be expected to continue in a stop-start fashion.

In short, when one looks at the five post-war structural factors, it is hard to see how current fundamentals sit alongside the ‘War is Over’ market exuberance unless fiscal stimulus continues.

* * *

The Tactical View

Let’s now take a tactical cross-asset view. First, a recap:

The S&P 500 printed a record high of 3,393 on February 19, 2020, but just over a month had fallen over 34% to levels not seen since late 2016 – essentially wiping out more than three years of equity gains. Then the Fed turned the market on a dime: the backstop of an alphabet soup of liquidity programs, unlimited QE, and the promise to buy corporate debt jointly dampened tail risk, reduced volatility, skewed risk-reward ratios, and shifted investor sentiment. Of course, trillions of USD in global fiscal stimulus helped matters as well.

The high yield and equity markets turned in tandem, and other risk assets in the FX and commodity space eventually followed suit, albeit with a lag and with less gusto. The S&P 500 is once again forging new all-time highs.

We had expected risk assets to take another hit, and for safe-havens to find some relief into year-end 2020. This was based on the expectation that a second wave of Covid-19 infections, triggering regionalised lockdowns, would weigh on market sentiment.

While the second wave hit, and is still raging in many places, and regionalised lockdowns were seen, news of multiple Covid-19 vaccines proved a game-changer for risk appetite. The market looked through near term winter weakness to the light at the end of the tunnel. ‘War is Over’ is the theme, as noted.

After all, equities are forward looking, and are always trying to see round corners. Furthermore, the breakdown of equity moves was telling. At first, companies set to benefit from the corporate bond backstop rallied, as did equities sensitive to interest rates. Over the summer, the top five companies in the S&P 500 led the way and eventually ended up with a market concentration of nearly 25% of the entire index.

Those top-five companies –not all are in the technology sector, but mega-tech became a buzz name for the group- were either less impacted by Covid-19 than many others, or in fact benefited from the socio-economic forces created by the Covid-19 pandemic.

We know retail played a large role in the equity rally, with the ‘gamification’ of brokerage apps spawning a new breed of small investors happy to buy deep OTM options in tech companies, which created an outsized effect given the gamma impact on dealing desks.

As volatility fell, risk parity funds and vol-control CTAs bought more equities, momentum jumped on the move, and flows into US equity markets continued. Then came the vaccine news and the rotation into the ‘War is Over’ trade.

Looking ahead, we now seem to be in a market where good news helps drive value and re-opening stocks higher, while bad news pushes interest rates lower and helps drive growth stocks higher.

Moreover, as has been the case for many, many years now, volatility is key. As long as volatility remains suppressed, risk assets can find support; and historically, there is a strong link between central bank accommodation and the level of market volatility.

In short, as long as central banks are “rigging the game” the equity game will indeed be played.

Indeed, with global front-end rates low and likely to remain there for several years at least, there is a strong argument that volatility will continue declining and risk assets remain supported.

* * *

Perfect cocktail?

This environment looks a perfect cocktail for equities, with hope, dampened volatility, and low real yields creating a positive feedback loop encouraging continued inflows from systematic and discretionary funds through 2021.

Notably, this also fits the historical “post-war” pattern with US equities rallying in the year after both WW1 and WW2 ended, before retracing those gains after the initial euphoria worse off.

However, let’s think even more tactically and less big picture.

As we have laid out, low inflation remains the structural risk going forward, but on a tactical basis we must voice caution heading into Q2 2021 very low CPI base effects and a return to (new) normalcy could trigger a short-term rise in inflationary pressures, and/or fears over potential stagflation.

In particular, commodity prices may help push inflation up. We already see this dynamic in commodities, driven by: genuine supply-demand; a weaker USD; central-bank liquidity; and the general ‘War is Over’ risk-on search for peacetime yield.

Historically, such fluctuations in commodity prices would not be a surprise. After both WW1 and WW2 we saw an initial pop higher in oil prices before a sustained downturn. Our house oil forecast for the next few years sits in line with this pattern.

Indeed, we see potential upside for oil prices in the coming months, even if only driven by USD weakness. The theoretical link between a lower USD and commodity prices is well known, but there is a mechanical impact as well. For example, if a European pension fund has to allocate 100bn to the Bloomberg commodity index, then a 10% rise in EUR/USD will force them to buy 10bn of commodities to maintain their allocation target.

We strongly suspect the Fed will look through a temporary rise in inflation, but it could shock markets for a while: after all, the biggest risk facing US stocks is the mere thought of higher rates. For consumers, however, it will mean a drop in real incomes on top of the Covid shock: recall the Arab Spring followed the last global commodity-price surge, which was hardly ‘risk on’.

Admittedly, for stocks the key question is what the market sees as the driver for any near-term higher yields: if it is better growth and inflation prospects, then value stocks may still outperform growth, and cyclicals outperform defensives.

In the rates space, US breakevens are arguably a better way of playing a temporary rise in inflation than nominals, as the Fed may increase the WAM of its Treasury purchases to lean against any rise in real yields. That said, given the moves observed over recent months (Figure 11) one can argue breakevens are already pricing in a similar story and upside could be limited.

To reiterate, we remain firmly of the view that from a structural perspective US rates will remain low for the foreseeable future.

* * *

Dollars – and sense

On the USD, the recent sell-off has been brutal, and the inverse relationship between it and equities remains intact.

In the coming months, there is little reason to see this weak USD trend changing. Further out, however, it is useful to question how long USD weakness can be maintained. The huge structural supply/demand imbalance in the Eurodollar market has been temporarily balanced by Fed policies, including swap lines and the FIMA repo facility. Nonetheless, USD liabilities outside the US are still massively higher than the availability of USD there as measured by FX reserves. (See here for more.)

This will be even more the case if the US is unwilling or unable to provide massive fiscal stimulus. This would imply a smaller fiscal deficit and so a lower net supply of USD to both its economy and to the rest of the world – and far lower growth to boot, meaning less global exports to it. In short, there is likely more of a floor for the USD from here than expected, which means global reflation themes cannot be driven by that trend alone.

‘War is Over’ (Reprise)

However, risk assets can arguably outperform over the course of 2021 even if we see a lower rate of GDP growth than the disappointing average in the decade before Covid-19. To our mind, there are three main risks to this view, however.

First is central banks tightening monetary policy. This seems extremely unlikely. In the last rates cycle, only the US and Canada among developed markets raised their policy rate by more than 100bp, after many years, and the Fed’s attempt to unwind its bloated balance sheet did not last long before being more than reversed. Central bank escape-velocity will be harder to achieve this time round. Nonetheless, fears of reflation happening earlier than expected may be seen in H1 2021 due to a combination of base effects, commodity prices, and post-Covid joie de vivre on headline inflation. Tactically, this must be noted even if strategically it is a blip in the opposite trend.

The second is governments implementing tighter fiscal policy. It is important to note that while there is little official rhetoric about a return to austerity – quite the opposite in fact– there are also a range of actions, overt to covert, and large to small, which suggest that this is what may still happen anyway. For example, payment of deferred tax payments or the reversal of VAT cuts, to say nothing of pay freezes or new tax hikes. After all, the alternative is fundamentally too challenging for the conservative central bank/Treasury economics teams to embrace. History also suggests we will probably get this wrong.

The third is the USD. Any new global dollar liquidity squeeze, driven by either a US recession, the need for even looser fiscal and monetary policy in other economies, or geopolitical tensions/instability, for example, would push USD higher and risk firmly off again. In a post-Covid environment, are global ‘wars’ over or just getting started?

In short, when one looks at the three risk factors above, current fundamentals arguably *do* sit alongside the ‘War is Over’ market exuberance – if one thinks politicians will act correctly ahead.

Yet who is it starts the wars, may we ask?