Over the past few weeks, it’s been notable that bond markets, both in the UK and in the US are starting to price the risk of higher inflation pressures, as long-term yields move to the upside.
Yesterday US 10-year treasury yields jumped sharply higher to 1.3%, in a move that suggested that markets were either starting to become increasingly concerned about inflation risk, or more confident about an economic rebound, depending on your narrative. This move higher in yields unsettled equity markets as the day wore on, despite new record highs for US stocks, with the result, that after an initially positive start markets in Europe and the US slipped into negative territory, and closed marginally lower on the day.
Combined with sharp rises in energy and commodity prices, there is rising concern that higher prices will not only choke off any post-pandemic recovery due to higher borrowing costs, but they could also crimp future consumer spending due to higher living costs. This caution appears to be manifesting itself into this morning’s European open, which looks set to be a mixed one, with Asia markets also trading in a similar fashion.
Here in the UK, since the beginning of this year we’ve seen UK gilt yields rise from lows near 0.17% to be trading above 0.6%, which is quite a significant move in the wider scheme of things, especially when short-term 2-year yields are still negative. This move in rates reflects a sharp rise in market inflation expectations, in response to the large-scale fiscal stimulus which is expected to get unleashed in the coming months in the US, as well as a lesser extent here in the UK.
We’ve also seen sharp rises in commodity prices, notably copper and crude oil, both of which have moved sharply higher since the beginning of this year, with oil prices up over 20% year to date. This rise in inflation expectations has for now not been reflected in higher headline CPI numbers, and probably won’t be for several months, however that could well start to change over the next few weeks, while consumers will notice straightaway when they go to fill their cars up when lockdown gets eased.
In recent months headline CPI numbers have fallen below the radar a little, however given the sharp rise in 10-year yields since the start of this year in the US, as well as here in the UK, fears over a sustained rise in inflation are starting to stalk the markets. This rise in prices isn’t expected to manifest itself in today’s January numbers, however the headline CPI numbers could start to get more interesting as the year progresses. Expectations are for UK inflation to slip back to 0.5% from 0.6%, with core prices also set to decline to 1.3%, from 1.4%.
The place we might start to see inflationary pressures build up is in factory gate prices, and for now these still remain fairly benign, however input prices have been rising for several months now, from negative lows of -4.6% in April last year, with an expectation of a rise of 0.6% in January. It’s a similar story for output prices, though they are still expected to remain negative at -0.4%.
While the UK economy is likely to see consumer spending weaken in January, the US economy is set up for a rebound with the latest retail sales numbers for January, which are due to be released later today. After a decent recovery in the aftermath of last year’s April lockdown, US consumer spending saw a fairly strong rebound as US consumers spent their stimulus cheques, giving the economy a decent lift through Q2 and Q3. This growth started to slow quite markedly in Q4, as the expiry of certain unemployment benefits, uncertainty over the US election, along with the imposition of tighter coronavirus restrictions started to weigh on consumer confidence.
This consumer slowdown along with the political deadlock on Capitol Hill over a stimulus package saw retail sales in November and December slide back quite sharply, by -1.1% and -0.7% respectively. Since then, the economic data has picked up markedly, helped in some part by the new $900bn stimulus plan that was agreed at the end of last year, and expectations over another $1.9trn later this quarter. This optimism is likely to translate into a rebound in consumer confidence and ergo a possible rebound in consumer spending, after a disappointing Thanksgiving and Christmas spending period. Expectations are for a 1% recovery to start the year, which could well continue into the rest of Q1.
Today’s FOMC minutes are likely to be somewhat dated given recent events, nonetheless they could offer an interesting insight into some of the discussions that took place around the risks of a sharp rise in inflation. In the lead-up to the January Fed meeting we heard from several Fed officials, including Raphael Bostic of the Atlanta Fed, who suggested in contrast to the December messaging of lower for longer, that we could well see a taper of the $120bn monthly asset purchase by the second half of this year, and a rate hike before the end of 2022.
While Fed chief Jay Powell, along with vice-chair Richard Clarida, clamped down on this messaging at last month’s meeting, these concerns haven’t gone away given the prospect of another large stimulus programme, and a US economy that looks more resilient than some of the recent data might suggest. At the press conference, Powell was keen to stress that the recovery was still fragile, and a little weaker than had been the case in December, nonetheless concerns about higher prices weren’t particularly elevated in the short term.
His comments that the Fed was prepared to tolerate inflation above 2% for some time suggests that they might be prepared to look past any short-term inflation pressures. This does appear to being reflected in bond yields, with the short end fairly steady, however long-term inflation expectations are rising quite sharply. As such it will be interesting to note whether the concerns articulated by some FOMC members in early January got an airing in the broader discussions, around what might happen if inflation pressures did start to accelerate beyond what members of the committee might be comfortable with.
Major forex pairs update
EUR/USD – failed at the 50-day MA and 1.2170 level yesterday, slipping back towards the 1.2070 level. This remains support with a move below 1.2060 reopening the risk of a move towards 1.1980.
GBP/USD – continues to edge higher, making a high of 1.3950 before slipping back with the 1.4000 level still within touching distance after breaking above the 1.3750 level last week. A break through the 1.4000 area has the potential to close in on the 2018 peaks at 1.4380.
EUR/GBP – further declines expected towards the 0.8600 area, by way of next support at the 0.8670 area. Resistance comes in at 0.8770.
USD/JPY – the current bout of US dollar strength has seen us break above the 200-day MA at 105.60, opening up the prospect of a move towards the 106.30 area. Support comes in at the trend line from the January lows currently at the 104.40/50 area.