The reflationary theme throughout financial markets took the total first quarter increase in US Treasury 10-year yields to 83 basis points. With the starting yield so low, this produced the worst quarterly return for US Treasuries since 1980.
A spike in US inflation in April and May appears mathematically inevitable due to the year-over-year change in energy prices; headline Consumer Price Index (CPI) could reach 3.5% with core around 2.5%. The more important consideration is the direction of CPI in the months and years after this spike.
We believe that inflation will prove to be sticky above 2% in the US for a few reasons. First, there is a lot of economic stimulus still working its way through the system, both fiscal and monetary in nature. Second, and related to the first point, the global recovery gathering pace is creating shortages in inputs; sustained higher producer price inflation (PPI) will feed through to consumer price inflation.
Inflationary pressures in services dropped during the crisis for obvious reasons connected to lockdowns; as the leisure sectors re-open, those businesses that have survived will seek to rebuild profit margins and balance sheets through raising prices. There is a huge pent-up desire for leisure activities, with demand outstripping supply even with some consumers likely to be more cautious about returning to life in public spaces again.
The classic inflationary feedback loop is wage inflation. The nuance we presently have is that additional income is not necessary to boost demand. There was already more than $2 trillion of excess savings in the US alone, and this was before the latest Biden stimulus cheques arrive. In aggregate, this savings pile will be spent over the next few years, providing a strong impulse to consumption. Wage inflation, however, is likely to fall as the leisure sectors reopen, entirely due to the industries involved employing a greater proportion of lower paid labour; this is a simple averaging impact.
Any form of protectionism, or trade barriers erected, will structurally add to price pressures too – a reversal of the disinflationary tailwind that globalisation has created for the past few decades. Technological advancements will continue to exert downward pressures on prices in most industries; this mega-trend will not dissipate, but there are enough other factors at work to conclude that an overshoot of inflationary targets should occur for the next few quarters.
Financial markets are involved in a battle, or maybe one could call it a negotiation, with the Federal Reserve (‘the Fed) about how high Treasury yields can go until it intervenes. The Fed has explicitly stated that it would like to see inflation above 2% for a sustained period to compensate for prior shortfalls, which is what average inflation targeting (AIT) means.
With the Fed likely to tolerate higher inflation, what would the trigger be for it to want to cap or reduce market yields? A steeper yield curve can aid growth through boosting the banking sector’s profitability and investor confidence in the recovery. The Fed will only be catalysed into action when yields have risen enough that it begins to either choke off growth or threaten to. The two most prominent transmission mechanisms would be a significant slowdown in US housing activity relating to higher mortgage rates or a taper tantrum that led to a 10% plus fall in US equity indices; the latter is the most likely trigger in my opinion.
It would be remiss of me not to mention the European Central Bank (ECP), which has increased the pace of its Pandemic Emergency Purchase Programme (PEPP) to alleviate upward pressure on bond yields. The ECB has not yet mentioned increasing the size of the PEPP so this is presently just a front-loading of the purchasing.
Eurozone inflation might not overshoot the 2% threshold but similar pressures to those seen in the US are also building. As vaccine supply picks up in Q2, the battle between bond markets and the ECB might begin in earnest. In the meantime, ECB officials will be taking pleasure in the rise in inflation expectations as vindication from the markets of their policies for the economic recovery.
The ECB’s preferred measure is to look at 5-year, 5-year forward inflation swaps, which takes out the idiosyncratic “noise” in the early years. This measure shows the expected average level of inflation over five years, beginning five years in the future (so covering a period five years from now until 10 years from now). The rise in market expectations here is clear to see in the chart below. Ultra-loose monetary policy combined with expansionary fiscal policy leading to inflation, who could possibly have predicted this?
So, for the foreseeable future, the negotiation between the financial markets and central banks will continue. Rates markets volatility and direction will be key for almost all financial assets.
Key Risks
