Does the combination of fiscal stimulus and post COVID-19 economic recovery create a higher chance of inflation? In March’s Market Voice, Ron Leven analyses trends in the U.S. dollar, U.S. Treasuries, and equities to assess the risk of an inflation surge over the next year.
- The dollar could become a source of inflation over the next year. Its current weakness could be followed by higher CPI inflation over the next six to twelve months.
- U.S Treasury rates point to an increase in inflation in 2022, which will then decline over the subsequent two years back towards 2 percent.
- Equity markets appear to have priced in a moderate loosening of COVID-19 restrictions this year, but anticipate a more profound change in 2022.
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In the last two issues of Market Voice, the potential of an inflationary impact from the unprecedented monetary and fiscal stimulus that is hitting the economy has been investigated.
The conclusion was little risk of inflation over the next few months given the excess capacity and still-high levels of unemployment plaguing the country. Indeed, while headline January CPI was up an annualised 5.2 percent from December the more meaningful ex-food and energy index hardly budged.
However, there is clearly risk of significantly higher inflation in the year ahead if the fiscal stimulus combines with the natural rebound as the pandemic recedes and eliminates the capacity overhang.
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Will the dollar influence inflation?
Figure 1 shows that the dollar could also add another source of potential inflation risk over the course of this year.
Although the dollar has shown surprising strength in recent months, the broad-based nominal index is roughly 8 percent weaker than a year ago (note the dollar change index is inverted). While the relationship is not tight, there is a tendency for dollar weakness to be followed by higher CPI inflation with a lag of six to twelve months.
The bottom line is that the risks of an immediate upturn in core inflation is modest, but there is clearly cause for concern for an inflation surge late this year and, particularly in 2022.
Figure 1: Broad dollar weakness and inflation
Figure 2 shows the rate on 10-year Treasury bonds and the 10-year TIPS inflation breakeven rate. Both rates plunged early last year in the initial stages of the COVID-19 shutdown.
Breakeven inflation began recovering as soon as the Fed announced its plans for an unprecedented pace of liquidity creation. The breakeven inflation rate has continued to surge into the new year and is now approaching 2.5 percent; the highest level in over five years.
The 10-year Treasury yield has been slower to react – perhaps reflecting Fed purchases – and rates did not start recovering until the second half of 2020.
While the 10-year rate is now trending higher, there is a substantial lag versus the TIPS inflation breakeven, with the rate barely testing the lows of two years ago.
Figure 2: 10-Year U.S. Treasury rate and 10-tear TIP inflation breakeven
Are bond yields set to surge higher?
While Figure 2 suggests that there is substantial upside for the 10-year bond rate, the full breakeven curve shown in Figure 3 makes for a less worrisome outlook.
The profile of the curve points to an expected surge in inflation next year, but then a steady decline back towards 2 percent over the balance of the decade. The basis for this expectation is in Figure 4 which shows the U.S. Treasury yield curve and the 1-year rate path that is implied by the curve.
The 1-year path, in turn, is indicative of expectations on the expected Fed response to the rise in inflation. Specifically, the curve implies a marginal rise in rates in the year ahead but more aggressive hikes in the years 2023 to 2025.
After 2025, the pace of rate hikes is priced to moderate, and by the end of the decade, rates will start to ease. It is probably not a coincidence that the 1-year T-bill rate is priced to peak at around 2.5 percent, roughly the same level the rate peaked at in 2018.
Figure 3: U.S. Treasury TIPS inflation breakeven curve
The market is looking for inflation to break through 3 percent next year.
The Fed is priced to remain on hold this year, but to start hiking rates in 2023 and continue gradual tightening into the latter part of the decade, with Fed Funds peaking at around 2.25 percent.
If the market continues to look for this rate profile, there is probably less upside in the 10-year bond rate than would be suggested by the historical link with the breakeven inflation rate.
That said, there is likely to be a reaction to raise rates when higher core inflation numbers start to print in the year ahead. The rate profile also suggests that growth – and inflation – may surge this year and next in response to the stimulus, but both are expected to revert back to the lower pre-pandemic trend by 2025.
Figure 4: U.S. Treasury yield curve and implied 1-year Treasury and Fed Funds rates
What are equity markets saying?
The relationship between current and future prices for equities is driven by discounting for interest rates and expected dividends, so it will largely mirror what is reflected in the yield curve shown in Figure 4.
That said, we believe there is some information on the outlook for economic recovery by looking at expected volatility skewing for selected stocks.
The impact of the COVID-19 shutdown has uneven across specific market segments. The travel and leisure industry was particularly hard hit, while companies providing services to the housebound soared.
The two charts below compare the volatility ‘smile’ for United Airlines and Netflix. The curve represents the implied volatility for out-of-the-money puts and calls; implied volatility typically rises as strikes move away from the current price, so the chart commonly looks like a smile.
Implied volatility for United Airlines stock for early next year is not the classic smile but rather a steady downward slope. The implication is modest demand for upside strikes in United Airlines, suggesting limited expectations for a rally.
The picture is very different for the beginning of 2023, with a picture closer to the classic smile. The market seems to be saying that United Airlines’s business will continue to be constrained by travel restrictions this year, but 2022 will see a significant shift towards more normal travel behaviour.
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Netflix was one of the biggest winners from the pandemic shutdown.
Whereas United Airlines stock is 38 percent below the end-2019 level, Netflix stock is 54 percent higher. As is true for United Airlines, the implied volatility curve shows little market appetite for Netflix upside for the year ahead but, unlike United Airlines, there is also little appetite for upside into 2023.
The market seems to be priced for modest loosening of restrictions on the economy this year but a sea-change in activity next year. This is roughly consistent with the interest rate profile of marginally higher rates this year, but sharp increases that will start in 2023.
Figure 5: Option volatility ‘Smile’
What are the prospects for inflation?
The market seems to be priced for modest improvement in economic activity this year but for much stronger growth in 2022. The Fed is priced to hike modestly next year, but for inflation and rate hikes to accelerate from 2023 to 2025.
Ultimately, the inflation pick-up is expected to be modest, allowing rates to peak at around the 2018 levels and start trending lower by the end of the decade. While this clearly reflects Fed tightening, we suspect there is also an assumption that the disinflationary trends of the past 20 years will reappear.
The primary risk is that a slow reacting Fed and a weak dollar spark a much more profound inflation response.
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