Inflation is the main macro theme in financial markets at the moment, with central bank liquidity and the potential for the massive $1.9 trillion US fiscal stimulus causing anxiety, especially given the Federal Reserve’s willingness to tolerate the economy running hot under new policy framework and Treasury Secretary Janet Yellen’s call for global policymakers to “act big”.
Treasury bond yields moved higher last week as inflation fears resurfaced. The 10-year yield climbed to 1.36 per cent on Friday, up more than 40 basis points from just over 0.9 per cent at the turn of the year and after reaching a historic low of 0.507 per cent in August 2020.
The 30-year bond yield also reached 2.1 per cent, the highest since February 2020, while the two-year to 10-year curve (the difference between the 10-year US Treasury yield and the two-year US Treasury yield) steepened to 121bps, the widest margin since March 2017. The five-year to 30-year curve also rose to 154bps, its steepest jump since October 2015.
However, with Wall Street ending the week on a flatter note and with equity valuations elevated, the increase in yields is giving rise to questions about whether further increases could prompt an equity market slide.
Much will depend on the evolution of inflation itself and for how long it persists. There are already signs of it in energy, housing, agricultural and commodity prices. There is also some speculation of a new commodity super-cycle related to a “new green deal”.
US producer prices jumped to 1.7 per cent in January from 0.8 per cent in December, with core Producer Price Index inflation at 2 per cent from 1.2 per cent in the previous month. In the many regional activity surveys, prices-paid indices are also at decade highs and small business surveys cite difficulties in hiring labour, which is likely to contribute to increasing wage pressure.
The Bloomberg Commodity Price index is at a record high and many industrial metal prices are at multi-year highs. The oil market is also in good shape, with futures prices up more than 20 per cent since the start of the year.
On top of inflation concerns, there were some strong gains in the broader macro data released last week, including US retail sales, which rose 5.3 per cent month-on-month in January, and in US industrial production (up 0.9 per cent month-on-month).
While these are numbers for just one month, a successful vaccine rollout and the lifting of lockdown restrictions later this year have the potential to release pent-up demand. This could be substantial considering that excess US household savings stood at $1.6tn at the end of last year and US real disposable income in 2020 experienced its fastest annual growth since 1984.
While spending on durable goods was boosted by Covid-19 last year, spending on services, which accounts for two thirds of total consumption, fell by 6.8 per cent. This implies there will be a bounce back in spending on services this year. The question is to what degree and how much of an impact it will have on prices.
Economists such as former International Monetary Fund chief economist Olivier Blanchard have indicated that price pressures are inevitable considering the scale of the stimulus, while others see output gaps, underemployment exacerbated by digitalisation and automation, and demographics all working to keep supply in excess of demand.
The other consideration for markets is the speed at which Treasury yields rise, as well as the level they reach. Gauging a “tipping point” in yields can be subjective, with markets often concerned by arbitrary big levels such as 1.5 per cent, 2 per cent or 3 per cent. Sometimes, rising equities can also co-exist with rising yields if they are underpinned by stronger economic growth, and not just associated with rising prices.
The other concern will be speed of the move in bond yields, with spikes in 2013 and 2018 bringing about sharp drops in the S&P 500 Index. Those reactions were as much to do with expectations for Fed tapering, plans which subsequently had to be reversed.
This brings us to the current Fed stance, which is likely to be just as critical. While the Fed may currently be “patiently accommodative”, by how much and for how long it can remain so is unclear. Although it may even adopt “yield curve control” to suppress bond yields directly, there is creeping doubt over the Federal Open Market Committee’s inflation tolerance and whether policymakers will be able to remain sidelined once price pressures truly emerge.
Tim Fox is a prominent regional economist and an adviser to Switzerland based St Gotthard Fund Management