As Deutsche Bank's Craig Nicol (and this website too) writes this morning "It's difficult to remember the last data release as anticipated as today's CPI report in the US" and adds that while markets may be at risk of being over sensitive to just one print, any upside surprise to the current sanguine consensus estimate (+0.2% mom / +1.7% yoy core) "will almost certainly put the cat amongst the pigeons", especially if last month's wages data is anything to go by.
And with inflation data suddenly the most important economic indicator, marking the focal point of the week for investors and markets, Deutsche Bank has decided to compare the current inflation regime with that in the 1960s.
Their work looks at factors leading to the sudden breakout in inflation in the 1960s and how there are similarities to today. Specifically, the German bank takes a look at how assets performed in the period when inflation was generally stuck between 1-2% in the first half of the 1960s, versus the period in the second half when inflation spiked to around 6% by the end of the decade. The graphs show what has happened in this decade so far.
Comparing the two periods
As DB's economists have discussed previously, during the 1960s inflation and inflation expectations were weighed down for much of the first half of the decade, before a combination of events helped to lift inflation around 1966. This included:
- a sustained decline in the unemployment rate below 4%,
- a signficant increase in fiscal deficits,
- a material pick up in health care inflation due to the introduction of Medicare and Medicaid,
- and a Fed which was to some extent constrained by fiscal policy and who may have overestimated economic slack and underestimated the sensitivity of inflation to slack.
In short, there are many eerily similar factors between this period and the current decade, where inflation has also been anchored for the best part of 8 years. Like the 1960s, the unemployment rate has fallen to around 4% from elevated levels with very little evidence of wage pressures. Inflation expectations are also stuck at very low levels, and there are similar beliefs that NAIRU was low and the Philips curve flat.
Figure 1 shows how various markets performed in the two corresponding inflation periods during the 1960s, with April 1966 acting as the turning point.
As the chart shows, asset prices were extremely divergent during the two periods.
Unsurprisingly there was a steep climb in Treasury yields post 1966, albeit with the curve heavily bear flattening. Yields were largely flat through the first half of the 60s (10y -1bp, 2y +3bps and 30y +34bps) however sold off thereafter, with 2y, 10y and 30y yields +380bps, +318bps and +183bps respectively from 1966 to the end of the decade.
The S&P 500 on the other hand, rallied +49% up to the point where inflation rose, but was broadly flat (+2%) for the last 3 and a half years of the decade when prices rose sharply.
However interesting to note that the perceived yield sensitive utility sector was a clear under-performer once rates went up. Given this period was during the Bretton Woods era, FX and Gold (and commodities) performance is largely irrelevant.
In the current decade asset prices have benefited hugely from the combination of ultra low rates, consistently low inflation and flow of money as a result of massive asset purchases since the GFC, but the last week or so is a reminder of what might happen if and when inflation starts to rise.
As Deutsche Bank concludes, "while today's number might be exagerated, and not move the dial much for the reasons discussed at the top, there are parallels between the situation now and that seen around 1966. If they are right, it has major implications for asset prices if and when inflation materialises."