Authored by Simon White, Bloomberg macro strategist,
It might look like it’s been defeated, but US inflation is poised to begin accelerating again soon. Stocks and bonds are unpriced for this outcome.
Markets are most sensitive at economic turning points. That’s because they have a tendency to linearly extrapolate trends. But when the data unexpectedly turns, the market is wrong-footed and has to quickly readjust.
We may not see it in July’s US inflation data due out today, but we are on the cusp of one of these turning points. Markets are linearly extrapolating the disinflation trend and are not priced for an inflation revival. Financial assets – stocks and bonds – will be vulnerable when it is clear a turning point is approaching.
What markets are anticipating for inflation’s path is a subjective exercise. But we do have one very good guide in CPI fixing swaps. These fix to monthly year-on-year CPI prints and are traded by inflation dealers who are highly incentivized to study the minutiae of the inflation basket and come up with a precise estimate for each month’s CPI – skin in the game.
Over the next 6-12 months fixing swaps are the most reliable read on the path of CPI, and they currently expect CPI to fall back to 2-2.5% over the next year.
Fixing swaps are in theory tradable by anyone with enough capital, so if the market in aggregate expected inflation to significantly deviate from the current expected downwards trend, it’s reasonable to expect it would show up here.
It doesn’t; but the market is quite possibly missing an approaching turning point. To see this we have to understand the reasons why inflation slowed in the first place. Surprisingly, the Fed has had little direct impact on declining price growth since its tightening cycle began last year (and there are plausible reasons why, discussed here and here).
Instead, outside of the idiosyncrasy of used cars, most of the net fall in the headline and core inflation rate has been driven by commodity prices, and by global disinflationary pressures, principally from China.
But after a year of falling, commodities have started to climb, especially oil. It is benefiting from a number of tailwinds, foremost among them buoyant liquidity conditions. Global real M1 growth is one of the simplest measures of liquidity and it continues to rise; oil and other commodities should do likewise.
Global food prices have begun to rise again too, after many months of falling.
This typically leads US CPI by about six months.
Overall, two-thirds of exchange-traded commodities have risen over the last month, while the CRB Industrials index – made up of non-futures traded commodities such as tallow, burlap and rubber – has also lifted convincingly off its lows.
Deflation in China, though, has been the principal reason why global and US inflation has slowed by as much as it has. If China had been able to recover more forcefully from the pandemic, commodities would be higher, CPI and PPI would be positive - not in deflationary territory as they are now - and US inflation rate (and Europe’s too) would not have come down as quickly as it did.
China’s PPI rose in July. If this trend continues, CPI in the US should not be far behind.
It’s early days, but if yields and PMI input prices in China – both of which lead PPI – can keep rising, then PPI should soon follow suit.
Don’t get blindsided, however, by waiting on inflation data to turn up before being convinced of price-growth’s return. Inflation is a heavily lagging economic variable after all. The non-reaction to China’s weak inflation data on Wednesday suggests the market is looking through lagging data, and scenting perhaps China has turned a corner as the cumulative impact of stimulus begins to gain traction.
It was the same last week when US yields rose on the back of rising term premium, the market getting a whiff of supply and thus inflation concerns. It’s a trend we can expect to continue: market-implied measures of inflation - such as fixing swaps and breakevens - anticipating a benign inflationary backdrop, while long-term inflation expectations saying something different, remaining elevated. As the chart below shows, that typically leads to rising term premium, and thus weaker bonds.
Moreover, term premium is also inconsistent with the heightened degree of inflation uncertainty. Inflation volatility remains elevated and has started to rise again, at odds with term premium that remains subdued.
Treasuries look prone to falling again once it becomes apparent inflation is not slain, merely dormant. Stocks too, as the rally continues to be driven by the highest-duration sectors and stocks.
It’s a delicate balancing act as excess liquidity continues to be supportive of risk assets for now. But once the inflation data is showing clear signs of rising, it will already be too late to get ahead of the selloff.
Markets may be most wrong at economic turning points, but nobody said detecting them in real time would be easy. Nevertheless, being aware one is coming is the sort of good fortune that favors the prepared.