- The US 2-year-10-year yield curve is reaching a 4-year high, as investors begin to price in inflation for the first time since the 2008 Global Financial Crisis
- The twin tailwinds for inflation, unprecedented fiscal stimulus and supply chain pressures, suggest that we could see a bout of consumer price steepening in 2021, enough to give central banks material for debate and longer yields to rise
- Having said that, we agree with the current view of central banks who consider it transitory and would be surprised to see real policy about-turns, like rate hikes or abrupt changes in quantitative easing as a result of elevated price pressures within 2021
“After another week with global equities near all-time highs, investors’ attentions are slowly shifting towards the bond market. The US 2-year-10-year yield curve is near a 4-year high, as global inflation expectations are picking up. Unlike March, when bond yields spiked as a result of the panic around Covid-19 and delayed action by the Fed, this time around, the move is more gradual and founded on solid reasons: the return of inflation expectations. In the US, five-year inflation expectations are near their highest levels since the 2008 Global Financial Crisis, with the UK and Europe following suite. Despite current inflation data, which still show very benign price pressures, investors are expecting, for the first time in 13 years, that prices for goods will materially go up in 2021. The reason is simple: after a very long time, price pressures come from both the demand and supply side.
- Demand side: Covid-19 related fiscal stimulus was not only unprecedented, but also expected to be withdrawn only after major economies have shown definitive signs of improvement. In other words, Treasury departments would rather err on the side of inflation rather than stifle growth. Central banks have concurred that growth is the primary concern and are willing to live with somewhat higher inflation for some time.
- Supply side: The pandemic has thrown the global economy off-balance, causing strong supply chain pressures. These are exacerbated by the plans by many companies to re-stock, as they are afraid that these pressures may persist throughout the year. Purchase Manager Indices, (PMIs), a credible forward-looking indicator, suggest record-acceleration in input costs. The surveys also highlight the rising costs for raw material, with some analysts saying that we could see the beginning of another 15-year commodity super-cycle.
“Inflation is an oddity that may well dominate discussion for this year. The base case scenario, one espoused by central banks, says that demand-side inflation is only temporary, the child of fiscal stimulus, bound to give way to more subdued demand as the economic damages of Covid-19 are uncovered and unemployment remains firmly higher than pre-crisis levels. Simply put, without reliable long-term growth, long-term inflation may be as absent as it has been in the past 20 years. When the pandemic is over and supply chains are repaired, supply-side inflation should also recede. An emerging scenario, however, suggests that the deflationary pressures of the past two decades, made possible by cheap manufacturing in the emerging markets and a streamlined global value chain, might dissipate along with the multilateral approach to global trade that fostered them in the first place.
“We are still in the camp that meaningful (over 2.5%-3%) inflation in 2021 is possible, even probable, but transitory in nature. Deflation, a situation of suppressed price growth, concomitant with a “secular stagnation” environment is nearer the norm one would expect once the pandemic dust settles. The fact that the Bank of England is considering negative rates, means that inflation is nowhere near their thinking at the moment.
“Having said that, we wouldn’t be too surprised if we get mixed messages out of central banks this year, a cause for volatility, when real-time data will begin to better reflect rising price conditions reported by manufacturers. This environment would be good for investors who have been frantically searching for yield in the past few years, which is why we wouldn’t expect long yields to remain elevated for a very long time. On the other hand, it could possibly reduce demand for emerging market / high yield bonds and dent the recovery of high-dividends stocks. Yet, make no mistake, we are on the side of central banks and consider all of that transitory in nature. We would be surprised to see real policy about-turns, like rate hikes or abrupt changes in quantitative easing as a result of elevated price pressures within 2021.”