LAST week the world lurched back from the precipice. Beijing stabilised its stock market and reported that the economy had expanded during the second quarter, at a better than expected 7pc. Greek politicians came to agreement (at least for now) with their creditors. Janet Yellen spoke about raising rates sooner rather than later, on the back of a recovering US economy. The dollar rose, buoyed by the prospect of higher rates, and the high-yield market recorded inflows once more.

After this welcome relief from the turbulence of the previous days, it was easy to believe that it was appropriate to pile back into the most crowded of all hedge fund trades, the reflation trade. This strategy involves betting on the dollar, US shares and US banks — and, for the more optimistic of investors, the same for Europe. Many analysts have upgraded their outlook for commodity prices — except oil, but that was because of an agreement with Iran that will increase supply, which has to be good news too.

So are the reflation bulls right? There was plenty of reason for positive thinking, beginning with Ms Yellen’s testimony before Congress, which prompted analysts at Barclays to say: “Recent Fedspeak and latest economic projections suggest that the hurdle to begin the hiking cycle is not very high.’’

But whether the bet on reflation is right for more than this brief moment in time depends partly on what could unnerve the market in the coming months. The world may have stepped back from the precipice, but for how long?

Moreover, well-behaved commercial banks, often a proxy for economic growth, reported respectable earnings, largely on the back of profits on their mortgage books. Citibank had its best single-day share performance in at least six months. Lenders will be among the biggest beneficiaries of future interest rate rises as tighter policy helps to improve the margin between what banks pay for deposits and what they charge.

The prospect of higher borrowing costs also provides confirmation that the housing market is finally improving. “We estimate existing home sales in June continued their recent upward momentum, probably making another business-cycle high as homebuyers rushed to get hold of the diminishing supply of affordable homes,” analysts at Credit Suisse note.

On balance, although the labour market continues to emit mixed signals, both job growth and (at long last) wages are improving.

But whether the bet on reflation is right for more than this brief moment in time depends partly on what could unnerve the market in the coming months. The world may have stepped back from the precipice, but for how long?

Inflation, as always, is one of the more obvious risks. But it is also one of the least likely risks, despite concerns over the labour market. Deflation, whether the good kind that is the outcome of improved productivity or the bad kind stemming from weak demand, is probably a stronger global force today than inflation. The 7pc growth in China’s gross domestic product reflects the continued power of its economies of scale in manufacturing higher-quality but still relatively cheap goods.

A more likely threat to the reflation story is contagion from a recurrence of instability, whether from Chinese markets, Greece, the Middle East or a hitherto unnoticed corner of the globe.

Japan had a down day when fund managers facing redemptions in China had to take profits in Tokyo to meet those requests. In a world where leverage remains high, instability should be assumed. Leverage, whether in China or the US, means markets — and lofty asset prices — that are built at least partly on sand.

Even more worrisome is the prospect (finally?) of the end of easing. The easy money that led to asset price inflation and the reflation trade could contain the seeds of its own undoing. Even as the Fed moves closer on its zigzag path to normalisation, it has downgraded growth prospects for the year. Moreover the recent history of Fed growth predictions has been a pattern of overly optimistic projections and subsequent downgrades.

“As Goldilocks ends, and monetary policies become on balance less helpful, returns likely mean-revert and volatility rises,” Citigroup analysts note.

These days, only an unthinking bull would not hedge its reflation bet.

henny.sender@ft.com

Published in Dawn, Economic & Business July 27th, 2015

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