The most recent inflation readings in the US and UK have both been higher than expected. First, we had the highest US consumer price inflation reading in 13 years, hitting a 5% year-on-year rate for May – above economists’ forecasts and considerably ahead of the US Federal Reserve’s 2% long-term target. This week, the UK’s Consumer Price Index (CPI) rose to 2.1% for the same period, above the Monetary Policy Committee’s “target” level of 2.0%.
This is not just a UK or US phenomenon; according to JP Morgan, global core inflation is running at a 25-year high. Yet bond markets seem unflustered. US and UK government bond yields have nudged a little higher over the last week but are still within the range they have traded in since March. A big shrug from the bond market is perhaps not the reaction one would expect. Has the market become complacent about underlying inflationary forces and the risks that central banks may act to curtail them sooner rather than later?
It seems clear that the market has dismissed the last two US inflation readings – April’s 4.2% was also comfortably ahead of consensus forecasts – as transitory. Some of the increase is due to base effects; this is particularly the case with regards to energy prices. Aside from energy, there were notable increases in used cars and truck prices and transportation services.
However, supply bottlenecks are occurring throughout the goods sectors. There has been a lot of press attention on the rising costs of building materials. Another example is surging food prices, which the United Nations recently reported had reached a 10-year high in real terms.
The reaction to May’s US CPI can be seen below in US 10-year government bond yields. The slight move lower contrasts with the moves seen at the turn of the year when inflation expectations rocketed as part of a ‘global reflation’ trade.
The main question is whether this inflation will prove to be a blip or whether some driving forces are not so transitory. What is clear is that demand for many goods is outstripping supply. This is likely to continue as other economies join the US in the re-opening trend. In my opinion, a demand impulse will last for a few years as excess savings are gradually spent.
Obviously, a lot of the pent-up demand is for services. There are also signs of price increases coming through in services as those businesses that survived the crisis look to rebuild profits.
It is clear to us that some of the inflationary forces we are seeing are structural rather than cyclical in nature. One interesting and important development in this respect is occurring in the labour market. The latest Job Openings and Labor Turnover Survey (JOLTS) showed job vacancies in the US hit its highest level since the survey began 20 years ago. Most US states are still providing enhanced unemployment support so there has been less incentive for people to find work.
With the US economy re-opening and labour in high demand, it would be sensible to assume that higher wages are likely to be offered to entice people back into work. A meaningful movement in wages could see the Fed act to tighten policy sooner than current yields would suggest.
So far, however, inflationary pressures have been largely dismissed by central bankers as transitory. Clearly, there is no formal definition of how long this transitory period will last; my hypothesis is that if US inflation is still at elevated levels – above 3% – by late August/early September then it will concern the Fed.
At the Fed’s most recent policy meeting, it suggested that interest rates may be raised in 2023, earlier than its previous forecast of 2024. But it didn’t state when it might start tapering its monthly US$120bn bond purchases.
The Fed’s Jackson Hole meeting in late August has sometimes been used to convey a change in policy over the last few years – we think this year it could be a milestone for the Fed to signal an impending tapering. If inflation expectations become unanchored before then the Fed might have to act sooner, but my central case is for a late summer US monetary policy change, earlier than many bond investors are pricing in.
With this expectation, how have we positioned the Liontrust Strategic and GF Strategic Bond funds? We reduced the funds’ duration when US 10 year yields hit 1.53% following its rally from 1.75%. The funds’ duration currently stands at around 3 years, which is well below our longer-term “neutral” duration of 4.5 years. Rates markets have exhibited remarkably low volatility, with yields staying within a very narrow range. We think there is no value for long-term investors simply buying bond beta and are very much focusing on alpha opportunities.
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