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The Big Conversation

Episode 86: Why is the market sending mixed inflation signals?

This week we break down the mixed signals coming from the market and hard economic data surrounding the inflation vs. deflation debate. Bonds have rallied over the past 3-months sending yields lower in spite of the fact that concerns around inflation continue. We examine this divergence between indicators like Core CPI and bond yields, the factors like treasury issuance and low growth fears that may be driving this divergence, and the historical implication for other asset classes should yields move one way or the other.

  • Max [00:00:00] Should we expect inflation or deflation? This is the question on every investor's mind, but at the moment the market is sending conflicting signals. Today's U.S. Core CPI reading came in at the expectations of 4.3 percent. Over the past few months, US CPI has continuously surprised to the upside at the same time, as bond yields have surprisingly fallen, with the U.S. 10-year treasury yield having fallen from highs of over 1.75 percent down to local lows around 1.13 percent.

    [00:00:33] Before we get started, I'd like to remind you that if you have any questions about what we discuss in this episode or questions you want answered in future episodes, please post them in the comments below.

    [00:00:44] The reasoning behind this move is not fully understood. Some say the bond market is pricing in a lower growth environment as fears of Delta variant's effect on the economy swirl. Others point towards the stretched positioning and crowded short bond trade as a result of the consensus calls for higher yields. That positioning unwound in July and sent U.S. 10-year yields falling over 20 basis points in the period of a week between July 13th and July 19th. For now, those pointing towards positioning are having their day in the sun as yields have reversed sharply off their bottom on August 4th. Inflation break evens are yet another indicator that just isn't buying this inflation narrative. The 10-year break-even rate is still hovering around 2.37 percent, almost 20 basis points below where it peaked out on May 12th. This coinciding to the day with the first big surprise CPI print above the Fed's 2 percent target since April of 2020. When Roger Hirst discussed this very same question back in June of 2021, he highlighted the correlation between the depletion of the U.S. Treasury General Account and falling bond yields. Since then, this trend has continued. Rather than issuing new debt and increasing supply in the bond market, the U.S. Treasury has been drawing down the TGA and approaching pre-pandemic levels. Now the TGA may be approaching pre-pandemic levels, the government spending is not. If the Treasury doesn't want to draw down the TGA too low, new issuance will be necessary. That is exactly what we are getting in August. Over the course of the month, the tentative auction schedule has the Treasury set to issue bonds across the curve from 4-week T-bills to 30-year bonds. Will this new supply be enough to solidify the reversal in yields we've seen over the last week? Couple this with another CPI print above the Fed's target and the potential for a positive surprise on Delta fears, the conversation could quickly shift from a focus on low yields and deflation to higher yields and inflation. Another new factor to consider, since we last addressed questions around inflation and the bond market, is the potential for tapering of the Fed's QE purchases. Fed officials are strongly signaling that the start of tapering is near. But unlike the taper tantrum in 2013, when this caused yields to spike, you're not seeing the same investor behaviour. At the time, bond investors front ran the Fed's policy and sold bonds, causing a massive spike in yields. But we aren't seeing that this time. Is this an indicator that the bond rally was more than just a positioning shock? Are investors truly concerned about the outlook for growth, or does this just reflect a shortage of bonds in the market from months of low issuance and continued QE? If those pointing to a positioning shock are right, or fears around low growth and Delta wane, we could see the Fed throw gasoline on the fire of higher bond yields. Fed officials are becoming more explicit with their language and pointing towards tapering sooner rather than later. Atlanta Fed President Raphael Bostic said that he is eyeing Q4 2021 to start Fed tapering, is open to even earlier tapering should the market remain strong. Looking a little further out, rate hikes may also be on the table. Both Bostic and Richmond Fed President Tom Barkin believe that the current metrics around inflation are satisfactory to check the box for one of the requirements to begin rate hikes and tapering. The other requirement is, of course, a better outlook for employment. Last week's non-farm payroll numbers were strong at 943,000 beating the expectations of 870,000 and improving upon the previous reading of 938,000. A few more months of strong numbers like this, and we could see tapering this fall and rate hikes much sooner than investors and the Fed were expecting just a few months ago. The issue, though, is that these metrics discussed by Bostic and Barkin are just their own personal benchmarks, and the FOMC has not settled on exactly which metrics or even the exact levels of those metrics that will initiate these policy changes. So what does this mean for other assets outside of the bond market? Previously, lower yields benefited long-duration plays like tech stocks, and that is exactly what has played out this time. The rally in bonds over the last three months has coincided with massive outperformance from the NASDAQ over other U.S. benchmark indices. And even longer duration technology plays like ARKK have dwarfed the NASDAQ over the same period. Lagging in this period have been reflationary assets like oil and copper and cyclicals like financials and industrials. The financials ETF $XLF is only up a half a percent, while industrials ETF $XLI is down 2 percent over the last three-month period coinciding with that bond rally. Other, more commodity focused industry sectors have fared even worse in this deflationary scare period. The materials ETF $XLB is down almost 4 percent over the same period, and energy ETF $XLE is down over 9 percent even with crude oil slightly up over the same period. These roles were reversed earlier this year when cyclicals and commodity focused sectors thrived as yields climbed in the first half of 2021. The relationship with yields though may seem tidy, but especially for reflationary assets like commodities, other factors need to be considered. During the period of strong performance for commodities they were buoyed by a weak dollar. This has not been the case of late, and the dollar, as measured by the DXY, is now trying to break through a key resistance level at 93. Both inflation and higher commodities have historically struggled to materialise in strong dollar periods. As well historically, China's credit impulse has been key to sustaining strong commodities. But this too, has recently rolled over, with China returning to lockdown's due to Covid resurgence fears, this impulse may be unlikely to return in the near term. For oil, other more market-specific factors are at play. OPEC+ is trying to meter out higher production alongside returning global demand but the goal of helping their partners increase production to meet domestic budget needs without crashing prices. This decision has caused a bobble in oil's stellar rally, but this could also be poor timing, with the potential for a second demand shock should lockdown's affect global travel. The unfortunate reality is that the movement of a handful of asset classes will not settle this inflation versus deflation debate. Only time will tell. And if history is any guide, even in retrospect, the debate will continue.

    I'd like to remind you once again that if you have any questions about what we discuss in this episode or questions you want answered in future episodes, please post them in the comments below. Thanks for watching.