For investors, the past year has been dominated by one factor: inflation. From April 2021, the US inflation rate began to climb rapidly. In the summer of 2022, headline inflation was above 8% while the base rate, excluding food and energy, exceeded 6%. This led to an abrupt change in monetary policy.
As of October 2021, fed funds futures have not priced in for a single rate hike in the next 12 months. A year later, the Federal Reserve (Fed) hiked rates by 300 basis points (bps) and fed funds futures currently suggest that rates could rise by at least another 150bps by March. beginning of 2024.
Soaring inflation has been a difficult situation for many long-only investors, including those in the traditional 60%/40% stock/bond portfolio. US stocks are more than 25% off their highs. Prices for 30-year US Treasuries have fallen more than 45% from their March 2020 highs. As such, the most important question many investors face is what could happen? to inflation? Is it returning to its pre-pandemic norm? Or will it persist?
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The bond market provides insight into what investors are currently pricing in inflation. Inflation break-even spreads between Treasury Inflation-Protected Securities (TIPS) and standard US Treasuries suggest that investors are pricing in a return to inflation rates of around 2.5% d by 2023 (Chart 1).
Figure 1: Breakeven inflation spreads on TIPS imply a rapid return to 2.5% inflation
However, one can reasonably ask: why do investors think that inflation is likely to return to normal so quickly? And what are the upside and downside risks of this scenario involved in break-even inflation differentials on TIPS versus standard Treasuries?
There are many arguments, both for and against, to the idea that inflation will soon return to normal levels. Let’s start with the supporters.
Arguments in favor of a decline in inflation towards 2.5% year-on-year
1. Supply chain disruptions have contributed to inflation and are easing rapidly. This is illustrated by the cost of shipping goods across the Pacific, which quickly returns to normal (Figure 2).
Figure 2: Supply chain disruptions could ease quickly
2. Many commodity futures curves are backward, suggesting that participants in these markets are anticipating lower crude oil, diesel and gasoline prices, as well as lower commodity prices. main agricultural products (Charts 3 and 4).
Figure 3: Futures traders rate the likelihood of lower fuel prices ahead
Figure 4: Agricultural markets price possible moderation in crop prices
3. Central banks have rapidly tightened their interest rate policy and should continue to do so. Investors could consider that the central bank’s monetary policy is restrictive enough to prevent further inflation (Chart 5). Central banks are also reducing their balance sheets through quantitative tightening (graph 6).
Figure 5: The Fed has already hiked 300 basis points and traders see another 150 basis points in the pipeline
Figure 6: Central banks reverse QE and embark on QT
4. US government spending, which rose from 21% to 35% of GDP at the height of the pandemic and which may have triggered much of the inflation, is rapidly returning to pre-pandemic levels. Tax revenues are also up and budget deficits are shrinking rapidly (Chart 7).
Figure 7: Government spending is rapidly declining towards pre-pandemic levels
5. The number of vacancies for new hires may have peaked – perhaps a harbinger of easing labor market pressures (Chart 8).
Figure 8: The number of job vacancies begins to fall rapidly, a sign of an easing in the labor market
Arguments against the idea that inflation will soon be subdued
1. The labor market remains very tight, with job vacancies far outstripping the supply of available labour. Moreover, wages continue to increase by more than 5% per year (Chart 9) and productivity growth remains mired at low levels (Chart 10).
Figure 9: Wage growth remains at 5% YoY and total labor income is up 8% YoY
Figure 10: Productivity growth has slowed at a breakneck pace
2. Although the Fed and other central banks have raised their rates considerably, their key rates remain well below the level of trailing inflation (graph 11). As such, are their monetary policies really restrictive? Can they contain inflation with negative real rates? This approach did not work very well during the 1970s, although we had less extreme negative real rates during the 2010s with little apparent consequence.
Figure 11: Real rates have never been as deeply negative as they have been
3. While government spending has moderated, protectionism, offshoring and outsourcing of production are on the rise. Will the increasingly fragmented nature of global trade keep upward pressure on consumer prices? Additionally, as trans-Pacific transportation costs have fallen, COVID restrictions in China, the Russian-Ukrainian war, OPEC+ production cuts and other factors could continue to disrupt trade.
4. Housing: 30% of the Consumer Price Index (CPI) includes either rent or equivalent owner’s rent, and rents have been rising at a rapid rate. Typically, rental costs follow the purchase price of a home with a one to two year lag (Figure 12). Thus, the 20% rise in house prices over the past few years, combined with a near tripling of mortgage rates, could force many potential buyers to stay in the rental market, which could push up rents, and therefore the CPI, much more. in 2023 and 2024.
Figure 12: Lease costs often follow purchase cost with a 1-2 year lag
At the end of the line
Judging by inflation differentials, investors anticipate a rapid normalization of inflation rates to the levels that prevailed from 1993 to 2020. Although many factors can be used to justify such expectations. there also seems to be a lot of upside risk. If these upside risks dominate, delaying a return to pre-pandemic inflation rates, it could lead to new challenges for equity and bond investors.