A flat tyre is thankfully a rare hindrance for cyclists and drivers. Among a number of interesting market signals and dislocations at the moment, one is the low-pressure warning for inflation expectations.
Inflation outside of asset markets remains missing in action after a decade of extraordinary monetary policy by many central banks. In spite of rising oil prices this year and hopes of a global reflation trade via China credit stimulus, developed-world bond markets are ruling out a sustained outbreak of inflation. Falling market expectations of inflation help explain why nominal bond yields loiter at the lower end of their recent ranges. In turn, the slide seen for industrial metals such as copper also reflects growth concerns being flagged by low bond yields.
In the near term, low yields help support risky assets such as equities and credit, but the bond market message is hardly reassuring as it suggests mediocre growth expectations and thus low future investment returns.
From early January there was certainly a pronounced rebound in market inflation expectations, reflecting the general optimism of economic recovery and less aggressive central banks. But that trend stalled in March and current US five-year inflation expectations have eased to their lowest level since early February. The 10-year inflation break-even failed to rise above 2 per cent in late April and now targets its late-March low of about 1.81 per cent.
A notable change of late is the usual relationship between oil prices and expectations of inflation. Normally a higher oil price propels inflation expectations higher, but as Steve Englander of Standard Chartered notes via this chart, this relationship has broken down.
Oil and inflation break-evens diverge
Inflation break-even, % (LHS), WTI price USD (RHS)
Steve also highlights how the prospect of higher US and China tariffs has not moved the inflation expectations needle.
“It is the more striking that it occurs during a period of concern about higher prices reflecting US tariffs on Chinese imports, suggesting that the combination of structural disinflationary forces and the risk of a downward output shock are driving the inflation expectations process.”
Another quandary raised by the lack of inflation pressure is how many labour markets are tight, suggesting that wage gains should at some point shift the needle. Many central bankers cling to the idea that a falling unemployment rate will eventually spur higher wages that results in rising inflation, an inverse relationship known as the Phillips Curve.
Callum Thomas at Topdown Charts has produced this stark chart of a blended unemployment rate across developed economies and its shows the lows of 2000 and 2007 have been taken out.
That leads some to conclude that inflation is coming, just give it time, while others contend that the forces of automation, ecommerce and globalisation are keeping consumer price pressures contained in the deep freezer. That’s been a longstanding trend and raises concern among central bankers of an entrenched negative feedback between actual inflation and inflation expectations.
As this chart shows, the Fed’s preferred measure of core inflation pressure, via the Personal Consumption Expenditure price index, has recorded an annual average pace of 1.56 per cent since the start of 2009. Apart from a blip above 2 per cent around March 2012, the central bank’s target has not been achieved during the current expansion.
On Wednesday, the meeting minutes from the US Federal Reserve’s April/May gathering will arrive. It is expected to read how the undershoot of policymakers’ core inflation target is seen as transitory, although low inflation expectations remains a worrisome development for officials.
Little wonder that the Fed is conducting a review of its policy framework, with early indications leaning towards tolerating an average inflation target of 2 per cent over time. Again, what’s interesting here is how the bond market is downplaying a Fed showing a greater willingness to let the economy run hotter in the future and stoke inflation.
This market response reflects a view that the Fed should be cutting policy now. So far this week, speeches by chair and vice-chair Jay Powell and Richard Clarida have affirmed that the Fed is no hurry to ease policy as low inflation pressure are seen as being “transitory”.
Some like Michael Darda at MKM Partners believe the Fed has little choice but to ease policy in the coming months, with the two-year Treasury yield since late March having been below the mid rate of the Fed’s overnight band (2.25 to 2.50 per cent).
“Slowing growth and weak inflation will likely lead the Fed to take out some insurance on the economic expansion later in the year and, thus easing monetary policy. A sustained two-year note yield that is below the Fed’s target interest rate hasn’t always preceded recessions (see 1995 and 1998), but has preceded Fed easing in virtually every instance.”
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Quick Hits — What’s on the markets radar
A trade reprieve sparks a modest bounce — A reprieve from the Trump administration for US companies that conduct business with Huawei over the next 90 days has helped calm global equities for at least Tuesday. Technology is enjoying the rebound, but watch the semiconductor sector says Matt Maley at Miller Tabak & Co:
“This is a group that was already facing a deterioration in their fundamentals, so the uncertainty surrounding the semis due to the change in the trade war is not making this group very appealing after its huge four-month (+47%) rally.”
Credit bears shift their sights — That’s the story for a sector of the US corporate bond market that has enjoyed an epic debt binge in the past decade. The triple-B-rated sector, fattened by record debt-funded mergers and acquisition activity, is slimming down in order to keep investment-grade status. The triple-B sector is the lowest echelon of investment-grade debt and has more than tripled in size towards $3tn since 2007. That has prompted fears of a credit market shock as the next economic downturn nears, a prospect raised by the Bank for International Settlements among others. Although Jay Powell was sanguine about corporate debt in a speech this week, the growth of private lending is what regulators should be monitoring.
Still, the performance of credit has been bolstered by the sharp drop in market yields this year, while in recent months big triple-B-rated issuers including Verizon, AT&T, Kraft Heinz and General Electric have all indicated efforts to shrink their debt piles.
As Bank of America Merrill Lynch note:
“While historically what prompts companies to delever tends to be an economic downturn, this time — due to super-easy global monetary policies — this large segment of issuers reached late-stage balance sheets much earlier in the cycle and is forced to make improvements well before the next downturn.”
That’s does not mean credit bears are missing out.
BofA note they expect erosion “among companies rated A or higher” and also highlight how high-yield borrowers “are expected to remain under pressure”, adding:
“In fact, the HY response is perfectly consistent with the current environment of decelerating economic growth and worsening corporate earnings.”
Pound finds a floor in May — Sterling briefly found some buyers in the currency market after Theresa May’s speech on Tuesday afternoon, before the reality that Brexit is an unresolvable mess clipped the rally. That leaves the pound mired at about $1.27 after earlier hitting its lowest level against the dollar since January. After 11 days of falls versus the euro that has knocked sterling to a three-month low, the currency remained in danger of extending that run late in New York. As fastFT’s Peter Wells estimates, this has been longest losing streak for the pound since the euro was officially adopted at the start of 1999, and eclipsing the previous record of nine down days from December 2008. Brexit packs a greater anxiety punch than this week’s European elections.
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