- Legend has it that former England and British Lions rugby player, Roger Utley, while coaching the Harrow School first XV during a tour of New Zealand, was becoming increasingly nonplussed at the poor quality of the breakfast spreads on offer at the hotels in which the touring party had been staying. “What sort of a country is it where you have 6 million sheep but you can’t get a slice of bacon for breakfast?”
- On 10th June, US CPI inflation printed 0.6% month-on-month in May (vs 0.5% est) for an annualised rate of 5.0% (vs 4.7% est). Core inflation registered a year-on-year rise of 3.8%, somewhat higher than the Fed’s 2% medium-term target. This was the highest back-to-back inflation print (April and May) since 1980. Of the various inflation measures from which one can choose, CPI is by far the most conservative (ie always has the lowest reading). Actual inflation in May may well have been higher.
- Judging by the reaction of the market and the assorted commentators, if inflation were sheep and the accustomed disinflationary pattern of the last 30 or so years was the bacon so desired for breakfast, then luckily for everyone, the buffet is loaded with crispy rashers. The all clear has been sounded by the bond market. May was the last inflationary ‘base effects’ month whose comparison to the lock-down-affected month of May 2020 has exaggerated current inflationary pressures. The bond markets says The Fed was right, inflation has been transitory, jog on.
Loads of bacon but no threat of inflation it would seem.
- The argument goes that the bond market ‘knows’ that the long-term effect of globalisation, demographic aging, technological advance and other secular trends, coupled with the deflationary effect of the large stock of debt in the world means it is impossible for a 1970s-style inflation to manifest itself. Asking for a repeat of the 1970s may be a bit of a straw-man argument (would you wear flares?). If the bond market is so jolly smart, let’s have a closer look at it.
- Wisdom has it that the short end of the treasury curve is more responsive to changes in central-bank policy, while longer-dated maturities tend to reflect better growth and inflation expectations. The Fed has a new more flexible inflation policy and is willing to run the economy hot until employment gets back to pre-pandemic levels. This involves tolerating inflation above 2% in the short term based on the principle of viewing overshoots as a form of catch up.
- Certainly, the short end of the US Treasury curve, generally trading around zero and with 2-year bonds yielding just 0.15%, is suggestive of no Fed hikes any time soon. If however one starts to combine current short-end bond yields with current inflation prints and short-term inflation expectations, a slightly odd picture emerges.
- Take for instance the US Treasury note 0.125% of June 2022, which was issued on June 2020 at a price of $99.86. With one more year until maturity, it is currently trading just through par for a mid-spread yield of 0.077%. In terms of cash flows, over the life of the bond one will receive four semi-annual coupons of $0.125 and $100 at maturity, so in total the investor receives $0.64. One could be fancy and discount all these cash flows, but with a coupon of nearly nothing and a discount rate of nearly nothing, it doesn’t really make that much of a difference, at least not for illustrative purposes.
- With May YoY CPI inflation printing at 5% (one can look at the headline not the core inflation figure as reality doesn’t distinguish between the two) and with 1-year TIPS inflation break-evens currently indicating 3.15%, by June 2022, the value of $100 invested June 2020 would be worth just $91.85. For the buyers of the 0.125% of June 2022 (the issue size was a mere $44bn), no contortion of rational expectation theory can explain a deal where you agree at inception to receive $0.64 in cash flows while losing $8.15 to inflation. That is plain stupid.
- While such an investment is clearly not rational, there is a rationale for why this bond trades as it does. Since it was issued, the Fed has bought 24.3% of the outstanding 0.125% June 2022 through its system open market operations (SOMA), the business end of the quantitative easing (QE) programme. This excess demand at the short end of the yield curve increases prices and suppresses yields, even in the face of extreme short-term inflationary pressures.
- In addition, since March, the US Treasury has been running down its reserve balance at the Fed. During the Trump administration, the Treasury General Account (TGA) rose from around $400bn to $1800bn, and since March 2021, this process has gone in reverse (see the graph below courtesy of the St Louis Fed). Running down the cash balance at the Fed means the Treasury has had to issue fewer bills and bonds. Bank reserves have risen as cash enters the system from the TGA but this hasn’t led to a rise in bank lending, in part because of the relative decline in T-bills and bonds issued by the Treasury which form a critical part of the bank lending process as they are considered the most pristine form of collateral. The combined effect of QE and lower Treasury issuance while the TGA balance has been run down since March have together had a depressing effect on yields which looks very much like deflationary trends taking effect.
Source: St Louis Federal Reserve, as at 16th June 2021
Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.
- If the short end of the curve is about the central bank’s monetary-policy expectations, then further out one sees inflation and growth as the key drivers, at least on paper. 10-year US Treasuries yield 1.46% at the time of writing. 10-year TIPS break evens are at 2.34%, and therefore 10-year real yields are at -0.89%. The inflation signal here reflects almost perfectly the Fed mantra that medium-term inflation expectations are well anchored, although there may be some short-term over shoots as the Fed tolerates higher-than-usual inflation in the interest of full employment.
- Another measure of the 10-year real yield is to subtract CPI inflation from 10-year nominal yields. The graph below shows exactly this, but over a long time horizon (since 1960). The current reading of negative 3.5% only bears comparison the oil-shock events of the early-to-mid1970s and the late 1970s / early 1980s. Those who remember their history will know this was a period of shocking inflation, extreme dollar weakness, and rampant commodity inflation, especially with respect to oil, gold and silver.
Source: Bloomberg, as at 16th June 2021
Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.
- If one listens to the commentary coming from corporates at present, one would recognise the inflation language of the 1970s suffusing almost every investor and analyst conversation. Just in the past week, the list of companies talking about price rises being passed on to customers includes, but is not limited to, Restaurant Group, Unilever, Procter & Gamble, Chipotle, Smuckers, General Mills, Campbell Soup, and Starbucks. The Chinese producer price index (PPI) for May came in at a staggering 9.0% (vs 8.5% est), in part reflecting the strength of US import demands as seen through the record US current-account deficit. Readings like this suggest China will be exporting inflation globally along with its goods.
- On the other hand, the dollar DXY index is weak but holding at around 90. Gold is remarkable in that despite inflation having been top of mind for much of 2021, the gold price is down on the year. Silver is up small, but much less than the base metals. West Texas is up at $71.50 and showing some signs of life.
- Overall however, if one takes the bond market, the dollar and especially precious metals, the market is shrugging its shoulders and is saying ‘whevs’ to inflation. Yet if one goes back to the earlier example of the 0.125% of June 2022, it doesn’t sound right to say anyone owning that bond is ‘looking through’ inflation – on the contrary, that particular investor is taking it right on the chin. A 0.07% yield to maturity while CPI is at 5% doesn’t so much look like financial repression, but in fact it is financial repression.
- At this point, one might start thinking that the bond market is pricing neither inflation at the short end nor deflation further out along the curve with any degree of acuity. In fact one might go as far as to say that circumstances have rendered the price discovery process meaningless at this point, and any conclusion about that the bond market is saying about inflation, deflation or anything else for that matter is now largely irrelevant.
- This feels like a very dangerous situation. If the bond market isn’t communicating to us about future growth and inflation expectations, then the price levels of risky assets such as equities and credit can also be called into question. Veteran macro investor Stan Druckenmiller expressed exactly this sentiment during a recent CNBC interview in which he said “the market isn’t speaking right now”, adding that market participants will continue to ignore all risks “until the Fed stops cancelling market signals’”.
- The Fed may announce some policy changes at some point. The Jackson Hole meeting in August is sometimes the venue for new policy announcements. There is a chance the Fed might twist bond purchases further out along the curve or introduce a permanent repo facility to keep short-end rates above zero. There are calls from former Fed employees for a prompt end to Fed QE purchases of mortgage-backed securities. The next Fed meeting is on 16th June.
- At a less granular level though, the base-effects argument for high inflation is now over. June 2020 saw the US reopening and thus inflation comps become much easier. If inflation persists, whether through supply bottle-necks which prove less transitory or a growing realisation that fiscal deficits are here to stay (the main takeaway from the recent G7 meeting) and that central banks will continue to monetise them, then the bond market is priced totally wrong, and with it all other asset classes. Any persistence in inflation going forward will likely see a move lower in real rates, a weaker dollar, and commodities prices rising, led by oil, gold, and copper. The Fed had better be right. It looks at present as though every asset class is making this bet. This is the point in the story in which we find out whether winning the peace will prove to be harder than winning the war.
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