Inflation: is it really a risk?
At the start of this year there was a major concern about the reflation trade and a spike in inflation that could cause the Fed to tighten US monetary policy earlier than expected. However, as we move through Q1, the Fed seems to be getting more dovish, and even though there are some notable inflation risks on the horizon, we don’t think that global prices will run amuck, at least not in the first half of this year.
The art of being patiently accommodative
At the end of last week, the Fed Governor Jerome Powell, coined a new phrase which is likely to become general parlance in the economic community in the coming months. During a speech at the Economic Club of New York that the Fed, he said that the Fed is adopting a “patiently accommodative” stance regarding monetary policy that “embraces the lessons of the past”. This is significant for every trader in every market: the Fed Governor has said that the US central bank will keep rates low for the long term, and that monetary policy will not be tapered or tightened for some time. The speech was more dovish than many had expected, and although US 10-year yields rose at the end of last week, breaching the 1.2% mark, we don’t think that the Fed will be turned. Global bond markets are not moving in line with Fed thinking, for now. As money comes out of bonds in the US (hence rising yields), it is piling into bonds in Europe; Spain and Italy are key beneficiairies, Italian yields fell at an all-time low at the end of last week. Also, we would expect some uplift from US yields as investors continue to pile into stocks. The week before last saw a record inflow into global stock markets, the chief beneficiary was US stocks. Thus, equity investors’ expectations that the Fed will leave interest rates and monetary policy accommodative for the long term, could be a reason why money is being pulled out of US bond markets (causing the yield to rise), and being placed into US equity funds, which reached another record high last week.
Why the dollar is the best way to trade a dovish Fed
Instead, where Fed dovishness could manifest itself is in the dollar. Interestingly, although US 10-year yields moved to their highest level since March 2020 last week, the dollar index actually fell. The relationship between US yields and the dollar has fallen apart, and since the Fed dovish, the dollar seems to be following the Fed’s lead, while US Treasury yields are moving in step with other market factors. Of course, the dollar will eventually turn, however, we do not think that that move will take place in the next few months. If we are correct and the Fed is what is moving the dollar right now, then current Fed dovishness will probably keep the dollar recovery capped for some time. Interestingly, a lot has been made of the 5-year, 5-year forward US breakeven inflation rate, which surpassed the 2% level in early February and rose to its highest level since late 2018. This is a measure of expected inflation in the medium term. The fact that the breakeven rate rose to a 2-year high was a sign that inflation was going to pick up. However, the breakeven rate turned slightly lower at the end of last week, even as 10-year US Treasury yields broke the 1.2% level, thus the St. Louis Federal Reserve’s website, which charts the 5-year, 5-year future breakeven inflation rate, will be watched closely by us at Minerva Analysis in the coming days.
The reason we are not worried about inflation
So why are we going against the grain and not too worried about inflation? We believe that commodity prices are the biggest risk to inflation, but central banks tend to view price pressures without the effect of food and energy prices, they look at core prices, which mean that rising commodity prices do not make us too worried about higher oil prices causing the Fed to hike interest rates. Added to this, concerns that savings built up during the Coronavirus pandemic could lead to a spending boom that will unleash waves of inflation are also off the mark, in our view. While post coronavirus spending could trigger a boom in foreign breaks and some spending, especially in Q2 and Q3, we think that the inflationary impact will not be significant and will not be sustained. This view was also echoed by Fed chair Powell in his speech last week.
Jobs, jobs, jobs
Employment and spare capacity is likely to remain the biggest dampener on inflation on both sides of the Atlantic in the coming months. The Fed chief sounded deeply concerned about employment, the unemployment rate has risen to 6.3% up from 3.5% before the pandemic, and recent jobs growth has been weak. This slack in the economy means that inflation pressures should not materialise, and rather than look at sharply rising commodity prices, analysts should instead look at sharply rising job growth, or sharply falling jobless claims, as a sign of when inflation will pick up. Neither of these are materialising even though the US economy has managed fairly well during pandemic. If we see a surge in employment, which we think is unlikely in the coming months, then the Fed chief may have to shift his dovish tone, until then the dovish tone appears justified.
What about Biden’s spending package?
Even President Biden alone cannot boost inflation. The $15 minimum wage is inflationary, but will have less of an impact in an environment where employment gains aren’t strong. Added to this, it is unclear how the stimulus package will create jobs and there will be fears that infrastructure spending will take too long to have an impact on the economy. Likewise, mailing cheques to every American household throughout this pandemic may have propped the US economy up, however, it can hardly be considered inflationary – US core consumer prices have trended lower since September and at 1.4%, the annual rate is hardly the stuff of Fed nightmares. Overall, it will take a herculean effort for the Biden administration’s fiscal stimulus to boost employment, which means that expectations of a wave of inflation coming down the line is misplaced.
Overall, this is good news for the dollar bears, and for stocks. In an environment where the Fed is likely to be in expansionary mode, or “patiently accommodative”, this is good news for tech stocks and US indices as a whole. Elsewhere this week, watch out for Eurozone GDP, the currency bloc is likely to have seen growth fall into negative territory for Q4. US retail sales report ex. Autos for January is released on Wednesday. The market is expecting a decent 1% rise, however this won’t be enough to make up for the 1.4% decline in December, suggesting that the big, inflationary spending boom in the US is still not underway.