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The 4.2% YoY US CPI number released last Wednesday, May 11, has stirred the inflation debate to new levels. The purpose of this week’s letter is not to take sides in the battle on whether we are bound to roll into a late-60s type of accelerating and unanchoring inflation setting or fall back towards the disinflationary conditions that coloured the post GFC decade. The purpose is to desensitise and objectivise the debate by zooming in on the true meaning of inflation. More precisely, we’ll address the important difference between changes in relative prices versus genuine inflation.
As was the case in 2008, the narrative that the US central bank is behind the curve is gaining traction. Maintaining price stability is a prime FED objective. In order to have a proper debate, we have to agree on the definitions. In March of 2020, the FED dropped rates to zero and unleashed an aggressive asset purchase venture in order to preserve the real and financial system from a permanently-damaging deflationary shock caused by the pandemic. In a deflationary shock, prices of goods and services fall, as do income and salary levels. So, the initial reaction (which seemed totally disproportionate to some) was required and measured, as global economies literally came to a stop. About 15 months later, the world hopes that mass vaccination will have broken the back of the pandemic. For sure, reopening economies trigger higher levels of volatility in economic indicator data prints. The official inflation series are no different.
Is the 4.2% YoY CPI print or the less volatile 3.00% for core (ex food and energy) CPI a game changer for the US economy? Maybe, a couple of swallows do not make summer. I tend to look at the world that is confronted by outsized global relative price pressures. Central banks have no power in combatting relative price changes. However, central banks can control inflation. Inflation refers to the drop in purchasing power of money the moment a central bank creates more money than the public wants to hold. As the antithesis of deflation, inflation manifests itself when all prices and wages rise, not just some subset of prices or at worse a single price. Inflation growth manifests itself the moment central banks grow money supply in an outsized AND persistent manner over and above nominal GDP growth. Persistent is key in this, or QE cannot and should not be applied all the time. We observe that at this very moment, global money supply growth has turned the corner. The biggest contributor to the MoM inflation rise of 0.8% last week was due to rising prices (+10.1%) of used, second-hand cars counting for 0.35%. Other single-item MoM price spikes where visible in hotel lodging (+7.6%) and airfares (+10.2%). So, we want to stress that travel-inflation, oil-price inflation, wage inflation or housing inflation used in isolation is a fallacy. Base effects and supply bottlenecks have created numerous relative price pressures over the past months and might surprise more over the next three months, as economies hopefully open in earnest.
Notwithstanding, economic agents are concerned. We need to focus on the speed at which the reflationary monetary impulse filters through wages and prices. The amount of slack next to the people’s expectations are two powerful transmission conductors. Last Friday, we learned that US capacity utilisation dropped towards 74.9%. Two weeks ago, we found stable labour participation, a surprise rise in the unemployment rate and disappointing monthly payroll numbers. To summarise, the US economy is still catching up and the FED’s second mandated goal of reaching maximum employment is years away. The latest Michigan expected inflation surveys do reveal some worry with the public at large, as 1-year out and longer-term (5 to 10 year) inflation expectations have risen towards 4.6% and 3.1% respectively. The latter might be influenced by the mixing up of relative price pressures and inflation. Effectively, relative price changes are not a monetary phenomenon. They exert themselves as a result of price adjustment driven by demand-supply imbalances. They do convey information about the scarcity of specific goods and services. A rising relative price can induce consumers to pass on the good in question and look for substitutes. A rising relative price will also entice producers to increase supply of the good in question. Vital information is collected through relative price moves and drives an efficient allocation of resources in market based economic systems. Inflation as such contributes no useful information towards our consumption, production or labour market options. Moreover, when making decisions based on an ill understanding of the difference between inflation and relative prices, outcomes might negatively surprise. Next time, when discussing inflation fear, please do not use arguments related to lumber, oil, wage pressure in specific cohorts of the labour market or temporary supply bottlenecks.
To a certain extent, though limited given the inward orientation of the US economy, the US dollar’s depreciation is another factor that puts upward pressure on the relative prices of many products and services. A greenback depreciation increases the dollar price of goods imported into the US. It lowers the foreign-currency price of all USD-denominated goods, produced in the US or outside of the US. A USD depreciation reduces the non-USD purchasing power of commodity exporters. If pricing power is on their side (think OPEC countries), the USD decline might induce them to raise profit margins, putting even more pressure on the USD prices of globally-traded commodities. The latter process is unfolding before our eyes today, but is not a reason to expect structural higher inflation. Then again, a weakening USD might be a sign of US inflation, if the US FED creates an excessive amount of money relative to other central banks. If the FED would blatantly become leading in its money supply growth, this might lead to structural higher inflation. That is not the case today. The ECB, the BoE, the BoJ, the SNB, the BoC…. they all push the pedal to the metal. The tinkering of QE programs by the BoC, BoJ or BoE are not significant.
With the above definition in place, we are aware that US financial markets have repriced to prepare for a period of above-average inflation. Given the wisdom of crowds exhibited by markets, we observe that these markets do not fall for the fallacy of mixing up relative price pressures versus inflation. 10-year US inflation expectations, as priced through 10-year US TIPS, put YoY US CPI inflation at 2.54% on average. Over the next 5 years, the market expects 2.71% annualised inflation. The newly-minted Average Inflation Targeting (AIT) FED policy instrument has been priced! Also, when we price 2-year – 2-year inflation annualised, skipping the base effect due to the deflationary shock of 2020, we arrive at an approximately 2.2% inflation reading: AIT right on course. The pricing occurs at the expense of deeply negative real rates and consolidating nominal rates.
On this side of the Atlantic, we have less reasons to cheer. German inflation expectations have normalised towards 1.44% over a 10-year horizon, still well below 2%. But, even more worrying, we notice that 5-year and 2-year inflation expectations stall at 1.35% and a poor 1.02% respectively. Indeed, a Japanese scenario still looms large for the EU. Adding insult to injury, the strengthening Euro is a bad omen. The ECB is mindful and monitors real rates closely. They should. EU real rates, especially in the periphery, ended the week on a backfoot. The moment base effects wane and the ECB cannot meaningfully adjust its inflation path over their projection horizon towards 2.00%, markets will not be kind to holders of European inflation-linked bonds.
In a week where everyone got surprised by US CPI and PPI high prints, stomaching heavy issuance in 10-year and 30-year US Treasuries, the US 10-year rate closed at 1.62%, a mere 4bp higher. The 30-year rate closed at 2.34%, climbing 6 bp. Clearly, we haven’t witnessed an inflation scare and US rate markets accept the transitory outcome. Dynamics can change, but the US bond market is not in a panic. Less noticed were the announcements of next quarters funding schedule as well as changes that will occur in the FED’s QE program. In short, they will buy fewer inflation-linked paper, fewer US Treasuries below 4.5 years and increase purchases at the longer end of the US Treasury curve. It was kind of a stealth operation twist that was announced. The media did not really notice.
Financial conditions in Europe are tightening. This could be a headline but is more of a warning. Rate normalisation can be applauded if followed by a surprising growth and inflation path across EMU members. We already expressed our concern last week and feel forced to repeat it this week. One observes EMU rate fragmentation across nominal and real rates. 10-year bunds added 9bp to finish at -0.13%. Spanish 10-year rates rose by almost 12bp, closing at 0.58%. Italian 10-year government rates swiftly passed the 1.00% marker, adding 11bp to retreat towards 1.07%. EMU government bonds post a -4.34% performance over 2021. Between end of 2019 and mid-May 2021, the EMU government bond sector still posts a positive 0.59% result. Perspective is an ingredient that gets lost more often than not these days.
Did the European investment grade (IG) and high yield (HY) bond sector levies brake over the past week? IG corporate bonds shed 48bp, whereas HY backed off by 22bp. IG corporates retrace by 1.27% versus an advance of 1.78% for the HY non-financial index since January 4, 2021. As economic recovery gains traction both sectors behave according to the path taken by rates. Well diversified portfolios benefit from the credit spread buffer that is still present. The best scenario for both is reached under low volatility conditions across rates and equity sectors. Both were tested over the past week.
Emerging Market debt showed its resilience with only a small -0.10% total return loss in EUR terms for local currency debt. Currencies, when measured in EUR, posted small positive returns, with Peruvian Sol (+3.45% in EUR Terms) and Colombian Peso (+2.45%) the clear outperformers. Turkish Lira was once again the laggard (-2.40% in EUR terms).
The commodity boom, supported by rising global demand, and supply glitches, have raised concerns about inflation around the world… In China, the producer price index rose +6.8% YoY, the fastest pace since 2017, whilst the CPI rose +0.9% YoY, slightly below the consensus forecast of 1.0%. The People’s Bank of China recognized PPI may rise further in the second and third quarter on higher commodity prices. They expect a stabilisation toward the end of the year as a result of increased global production and reduced supply shortages. In April, the PBoC, kept withdrawing liquidity from the banking system in order to prevent excessive leverage in the economy. Latest data show growth in broad money M2 aggregate has been reduced to 8.1% YoY in April, down from 9.4% in March. As a result, Total Social Financing has slowed to 11.7% from 12.3%. As a reminder, the authorities want to keep credit growth in line with nominal GDP growth. That should keep inflation worries well under control.
In Mexico, Banxico’s expected inflation path is shifting upwards, but convergence to the target (2%-4%) is still expected by 2022. The board now agrees that the balance of risks to inflation is biased upwards, although not unanimously. The message certainly has a small hawkish twist when compared to last month’s statement.
Inflation is not surging everywhere. The Philippines central bank held its benchmark rate unchanged at 2%, after weak economic performance and decreasing inflation. The Bank has also lowered its CPI forecast for 2021 to 3.9% from 4.2%, seeing the price index falling back to the 2%-4% target band. It stated that “sustained support for domestic demand remains a priority for monetary policy”. In India, CPI rose 4.29% YoY, which is down from 5.52% in March, mainly due to slowing food prices. With the domestic recovery under threat by another wave of COVID cases, those figures will provide comfort to the RBI to remain accommodative at its next meeting in June as well as over the next few months.
Today, the global YoY inflation print stands at 2.7%. Our models start to worry the moment global inflation rises above 4.00%. We’re not there yet at all. If we break such levels, monetary authorities might also push the brakes and tighten policy. That would be a deadly cocktail for balanced funds, as return correlation between equity and fixed income would turn positive.
I still belong to a camp that detects intense global relative price pressures, not a global inflation problem. Remember the key differences listed in this short letter when discussing inflation. Let the debate continue. Hopefully, the wisdom of crowds will prevail.