After anticipating economic recovery (it’s coming) markets are now trying to front-run the next phase of the cycle. In doing so they have priced in higher inflation and are testing the timing of the beginning of a new rate hiking cycle. The Fed is likely to reiterate that 2023 is the most likely start date. It needs to be a strong message because inflation is going to be higher in the next few months and demand could surge. It’s going to be a red hot game of poker between the markets and the central banks.
The stylisation of this economic cycle is marked by vaccine development and deployment (even in the face of new variants), rising immunity and falling infection rates, and a sequential lifting of social mobility restrictions and the commensurate increase in economic activity. The nuances are provided by differences in the speed at which this all happens between countries, the additional policy support that goes along with it and the extent to which the pent-up demand accumulated is realised in actual spending. The US is leading the way on most counts and other countries are in its wake. This week I looked at the current consensus forecasts for real GDP growth and inflation across the major economies. Nominal GDP peaked in Q4 2019, the US is expected to re-attain that level of activity this quarter while it could be at least two more quarters before the same can be said about the UK and much of continental Europe. The passage of the $1.9trn COVID-19 recovery stimulus bill in the US is a huge reason for the expected acceleration of the US economy.
Markets, of course, try to front-run reality. That explains the rise in equity markets since last March. As I have written numerous times, the twin drivers of huge policy support, and expectations grounded in the belief that vaccines would come, propelled market valuations in 2020. Now there is some attempt to front-run what many think is the next stage of the cycle – higher inflation and monetary tightening.
A quick check-in with reality. US consumer price inflation in February was 1.7% year-on-year. Excluding food and energy (core inflation), prices rose by 1.3%. If the monthly increases in the consumer price index in the coming months conform to the pattern of the last twenty years, the headline annual rate of inflation will rise quite quickly. Indeed, it could average above 3% in Q2. As a thought experiment, if the monthly increases in the balance of the year were 1.5x the historical averages, then inflation would be above 3% for the rest of 2021 and 2022. This is unlikely as I have not read any convincing argument that we have entered a new inflation regime (one in which wage growth was higher and all there was a slowdown in the effect that disruptive technologies have on pricing power). On an unchanged historical pattern of monthly increases, it would revert back to close to 2% next year. That is probably not enough for the Fed so it would ideally likely to see some (positive) break with the recent historical record on inflation. The market’s issue is that it doesn’t believe that the central bank can fine tune inflation. So, for years the belief was that inflation would undershoot and now the risk is that the belief has quickly become that it will overshoot.
Some transitory increase in inflation is likely. We have had disruptions to supply and demand in the last year and the expectation is that demand will come back quickly. So, in some parts of the economy – travel and hospitality – prices could rise a lot. This hump in inflation in Q2 will coincide with a boost to US household income coming from stimulus checks and with the further re-opening of the US economy as vaccinations are rolled out rapidly across the United States. The transfer of wealth from global savers to American consumers via the guarantee of the US federal government will be tremendously powerful in terms of the potential impact on nominal demand but also financial markets. Some of the cash might go into savings plans, some of which will go into equities (and not just the reddit betting type). The US could be red hot in the spring.
No reverse in yields yet
It’s hard to imagine that the rise in US Treasury yields is reversed when markets see, in the data, higher inflation and higher spending. So again, it is useful to think about what scenarios there are for yields. For now, markets seem to believe that the inflation increase in Q2 is a hump. Long-term inflation break-evens derived from the US Treasury Inflation Protected Securities (TIPS) market are at 2.2%. They have been rising steadily since last year and are now at the top of the 5-year range. I would argue that this is more or less consistent with the Fed’s average inflation target above 2%. A different way of looking at this is through forward markets. The 10-year/10-year forward break-even is currently 2.4%, which sends the same message i.e. long-term expectations in the bond market are consistent with believing the Fed. If that remains the case, then any further increase in the nominal bond yield requires the real yield to rise further. The 10-year real yield bottomed at -1.12% and is now -0.7%. Since the global financial crisis there have been two “bear” markets in real yields – in 2014 (which was driven by the taper tantrum) and then in 2016-2018 when the Fed was actually tightening monetary policy. The latter saw real yields rise by around 100bps. As such there is potential to go further than the 40bps move seen so far in this cycle. Imagine real yields go to zero – this puts nominal Treasury yields in the 2-2.5% range at some point this year.
That is not a forecast but a potential scenario. Other potential outcomes include an overshoot of that range if markets panic about inflation and the Fed being behind the curve in Q2. I mentioned just how strong nominal growth is going to be and that the gap between growth and yields is at a very wide level. Or it could be the case that the market peaks before 2% as global bond buyers see very attractive relative value in Treasuries. The European Central Bank has just promised to increase its purchases of bonds through the PEPP framework in the next three months to help stabilise European government bond yields and spreads. US 10-year Treasury yields are getting on for 200bps above the equivalent German yield.
Short to long
Prudently, it’s probably not the time just yet to increase duration in bond portfolios, although being short is much less attractive at 1.6% than it was at 0.5%. – there is an additional 1% of annualised carry that is being given up by being short now. Not to say that you can’t make money by being short – if the market moves to 2% in Q2 then that will be a profitable trade. For longer term investors, however, it usually plays to be long most of the time. An annualised move from 1.6% to 2% in 10-years would give a -2.1% total return today. An annualised move from 2% back to 1.6% would give a total return close to 6% (assuming a constant duration of the 10-year bond). Many bond investors will be eyeing levels above where we are today to start to re-build a positive allocation to duration as the year progresses.
Top o' the morning
We will hear from the Fed next week following its board meeting on 17 March. Unfortunately, there won’t be any St Patrick’s day celebrations so the Jay Powell press conference will be the highlight. Given that the stimulus bill has been signed by President Biden, markets will be looking to see how the Fed incorporates that into its own outlook. There will also be an update to the Fed’s forecasts and its interest rate “dot plot”. My feeling is that with the passage of the stimulus, the modest February inflation number and the ECB’s promise of a kind of yield curve control, some of the inflation panic in markets is passing. Growth has staged a recovery in the equity markets and credit markets remain extremely buoyant (record levels of new issuance including some jumbo deals like the Verizon $25bn one). If the Fed can settle some of the rate expectations and convince markets that 2023 is the year for rate hikes and not before, then we could be in for even more bullish market performance through the spring.
If only Manchester United could play away from Old Trafford all the time. They are unbeaten in 21 away games and last weekend, to my surprise, beat league leaders City. That was followed by a 1-1 tie back home against Milan. Still, the team are competing in two cup competitions and are well placed to secure a solid top-4 spot in the Premier League. Both Jose Mourinho and Louis Van Gal won trophies during their short stints as manager at United. Ole has not won anything yet but there is certainly evidence of all-around progress. Sunday sees a tough game against West Ham. I hope for some home advantage.