This article summarises the main points of our comprehensive analysis of the outlook for US inflation in the coming months.
As we come out of the hard pandemic lockdowns that imposed the deepest economic contraction on record, the US economy is reopening amid a rapid COVID vaccination rollout and an avalanche of fiscal spending. The big question for investors now is what kind of post-COVID economy will emerge?
Key questions for bond investors
In this context, one of the key questions facing fixed-income investors is whether the US economy may be heading towards higher inflation. And, if it is, will that inflation be temporary or persistent?
Consensus is for higher inflation to be transitory
The consensus among most US economists is that the increases in prices we will see in 2021 will be purely transitory, reflecting a mix of base effects and temporary supply bottlenecks as the economy reopens. Their argument is that inflation will thereafter return towards target, contained by the stability of inflation expectations, the muted response of wages to labour market pressures and a lack of pricing power in the corporate sector.
Potential for a regime shift
This consensus analysis, based on recent experience after the Great Financial Crisis, could well be correct, but in my opinion (declaration of interest: I am an inflation-linked bond portfolio manager) it underestimates the potential for a regime shift.
I would argue that, beyond the base effects and temporary bottlenecks, there are cyclical and structural reasons to see a firming of inflation pressures over the next few years, and that a regime shift towards persistently higher inflation is quite plausible.
So why might this time be different?
- The monetary and fiscal policy response to the pandemic is unprecedented in its scale, coordination and ambition. The sheer size of fiscal intervention poses a risk of overheating the economy, driving unemployment down to levels that will test how flat the Philips curve is at extremes.
- The pandemic lockdowns present an economic shock very different to the one that stemmed from the 2008 US housing market debacle, with its attendant damage to financial and household sector balance sheets, allowing for a much faster recovery. The adoption of an average inflation-targeting (AIT) framework will ensure that the US Federal Reserve (the Fed) is reactive rather than proactive in countering inflation pressures. Currently, the degree of coordination between fiscal and monetary authorities, as well as the easiness of each component, is almost unprecedented in peacetime. It is extraordinary that the objective of the exercise appears to be to generate a (mild) economic boom, rather than a ‘soft landing’.
- Global supply chains are being reconfigured, and the US-China trade relationship is becoming more adversarial. This looks set to reduce global competition and may strengthen US producers’ pricing power.
- Most developed economies, and that of China, are seeing a demographic reversal that will lead to a decline in working age populations. This will reduce global savings rates, drive up real wages and inflation and reduce inequality. Given high levels of corporate and government debt, electorates’ refusal to tolerate austerity and the imperative of avoiding a debt sustainability crisis, policymakers will be heavily incentivised to reduce that debt burden through an inflation tax.
The end of lowflation?
These arguments suggest, therefore, that China’s demographic reversal and the West’s new containment strategy via limits on trade, technology transfer and investment restrictions will, over time, throttle China’s deflationary impact on global prices of goods and services. The demographic arguments apply equally to countries in Europe, of course.
The pandemic has arguably accelerated these trends, having highlighted the financial vulnerability of large parts of the working age population, compared to the pension and healthcare protections afforded to the elderly. One can see that the public’s tolerance for the austerity that accompanied the Great Financial Crisis has evaporated, and the explosion in public debt that has come with the pandemic has been largely absorbed by central banks. Through their purchases, they have essentially printed money in exchange. Will the coming demographic pressures be dealt with any differently?
So, one really has to ask, will the inflation regime really stay the same? Are we really going back to a ‘lowflation’ environment? It is possible, but to assume that is the only plausible outcome is, in my view, complacent.
What are the implications for the US Treasury market?
As outlined above, I am increasingly constructive on the US inflation outlook, and see far greater upside risks than I did 18 months ago. Drawing together the arguments above, I come to a number of conclusions:
- In the near term, US Treasury investors are focusing on commodity prices, base effects and bottlenecks driving up the consumer price index (CPI). Most understand that these factors are transitory. However, there are concerns that the mix of fiscal and monetary stimulus could lead to the US economy overheating, and that underlying core inflation could then respond. The fact that the Fed is telling you that it wants to generate an overshoot in inflation makes it hard to dismiss the odds of that happening. Breakeven inflation rates will thus remain supported, and should trade above pre-pandemic levels. Inflation markets have of course already repriced a lot. Ten-year US TIPS breakevens have recovered from the pandemic crisis low of 0.55% to around 2.55%. The front end of the breakeven curve is already pricing several years of inflation overshoot, with 5-year breakeven spreads at around 2.75%.The opportunity in breakevens is perhaps now on the slope of the breakeven curve, which should eventually re-steepen. After all, if the Fed does achieve a sustained inflation overshoot, investors will begin to wonder whether they should reprice inflation risk premia further out on the curve. And if the Fed fails to generate that overshoot, the front end of the curve is vulnerable. The 5-years/30-years breakeven curve slope, at -40bp, is at its most inverted in history. That may be testament to the Fed’s new FAIT framework, but the temporary inflation overshoot scenario is priced to perfection.
- The Fed is repressing financial conditions, which means real yields will remain contained for now – at least at the front end, given the Fed’s policy rate guidance. However, at some point, the Fed will begin to remove accommodation. The first step will be a reduction in asset purchases, likely signaled in August or September and implemented in early 2022. Hence, longer-dated real and nominal yields look vulnerable in the near term, though any sell-off should be limited by the rebalancing needs of pension funds. The Fed has and will continue to tolerate increases in longer-dated real yields that do not tighten financial conditions in a broader sense. Calibrating that tipping point is difficult, but we estimate that 5-year/5-year real yields would impact other asset markets (i.e., equities) if they rose sustainably above 0.50%. At the time of writing, the 5-year/5-year real yield is at around 0.20%. If, and when the Fed has succeeded in generating an inflation overshoot, it will at some point have to tighten monetary policy - perhaps aggressively - to return inflation towards target. AIT, therefore, should deliver a higher terminal policy rate (and thus higher nominal Treasury yields) than the regime it replaces. Real yields, however, might on average well be lower over the cycle.
- Investors should not expect a smooth ride. Volatility in asset prices is likely to rise. The Fed’s FAIT framework is really a (vague) promise to be late in removing the punchbowl. That means the party in asset prices could yet get out of hand. Already we are seeing excesses in certain assets, as acknowledged by the Fed’s Financial Stability watchdogs. It is possible that the Fed will be forced to act and tighten policy before its FAIT framework suggests it should. The volatility and rotation between growth and value stocks shows how nervous equity investors are about higher real yields.
- Investors should think long and hard about whether we are still in a global secular stagnation environment characterised by excess savings, insufficient investment, muted inflation and low real yields. Demographics are reversing in a number of countries, savings rates are likely to decline over time, pension and healthcare systems will suck up resources, and some governments are launching significant infrastructure and climate change mitigation investments that will absorb spare capacity. Trend economic growth will slow further given population trends, but economies may well operate closer to full capacity. Heavy debt burdens will necessitate that real yields cannot rise too much unless there is to be a debt crisis. Since inequality has rendered austerity politically unacceptable, and since real yields must be repressed for debt sustainability reasons, central banks will have to remain the marginal buyers of government debt. At some point, this currency seigniorage will devalue currencies and fan inflation. If so, the bull market in government bonds may finally be ending.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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