In brief

• Year-to-date, 10-year US Treasury yields have risen about 50 basis points from 0.90% to 1.39% at the time of writing, a relatively fast pace of increase. The spike in yields reflects rising inflation expectations as well as stronger growth prospects, as bond markets price in a faster-than-expected economic normalisation on account of receding Covid-19 cases and a ramp up in vaccination efforts.
• This will increase the risk of near-term volatility in equities, credit, commodities and emerging market risk assets. Valuations are pretty stretched and concerns that the Fed may withdraw policy support prematurely have and will continue to affect risk sentiment.
• We believe concerns about high inflation, and therefore withdrawal of monetary policy support is premature. The Fed is likely to stay very dovish in the foreseeable future in view of the stalling labour market recovery. High unemployment rate and declining labour participation rate suggest plenty of slack in the economy which should contain inflationary pressure. The Fed’s firmly dovish stance will likely prevent a major sell-off in US government bonds and keep real interest rates negative, thus keeping intact the economy’s recovery from the pandemic and the broad rally in risk assets.

A new bogeyman

In January, concerns about froth in certain corners of the market, exemplified by the Reddit-fuelled GameStop short squeeze, triggered jitters among investors. Those fears have since receded. In February, markets buckled under the threat of a new bogeyman: Inflation.

Market based measures of inflation expectations in the US have risen sharply over the past few weeks. The 10-year US breakeven rates – the yield gap between the 10-year Treasury Inflation-Protected Securities (TIPS) and 10-year US Treasury bond – have risen above 2% while actual inflation data have been lacklustre to say the least. The Federal Reserve’s favourite inflation gauge, namely the core personal consumption expenditure (PCE), remains below the Fed’s 2% target at 1.5%. Other measures of actual general price changes including headline consumer price inflation are not nearly as high as expectations, at 1.4%.

As a result, long-term US Treasury yields have rebounded, and the yield curve has steepened. In a matter of one-and-a-half months, the 10-year US Treasury yield jumped over 40 basis points to 1.34%, a relatively fast pace of increase. Investors may not have bat an eyelid if yields rose steadily to about 1.5% by the end of 2021 on account of the economic recovery driven by the vaccine roll out. However, there are concerns that a sharp increase in long-term interest rates early on the cycle could choke the recovery by tightening financial market conditions prematurely.

In addition, the whole edifice of high asset prices, from stocks to real estate, relies on monetary policy staying accommodative and inflation risks remaining dormant. Any sudden withdrawal of policy support due to accelerating inflation could easily upend the risk-on narrative that has propelled risk assets higher.

Interestingly, the last time the fed funds rate was at crisis lows, the 10-Year US Treasury traded at yields of around 2 to 3% between 2008 and 2015, more than double where it is today. Aside from increasing inflation expectations, the recent rise in yields could reasonably reflect anticipation of a faster-than-expected normalisation of the pandemic-blighted US economy as Covid-19 cases decline and vaccinations become more widespread, as well as expectations of massive bond issuance to finance President Biden’s fiscal ambitions.

Back to inflation, concerns about accelerating price increases are not entirely unfounded but may likely be premature and overdone.

The tyranny of “base effects”

To be clear, the inflation rate, measured on a year-on-year basis is expected to rise this year, and may even breach the Fed’s 2% target in the next few months due to low base effects. In February last year, roughly a month before the full disruptive effects of the Covid-19 outbreak in the US took centre stage, core PCE inflation stood at 1.9%, 0.1 percentage point shy of the Fed’s 2% target. By April, this had fallen to 0.9%, its lowest level since 2010, largely driven by economic disruptions related to Covid-19.

Lockdowns in March and April alongside strict social distancing policies caused demand for retail, restaurants, air travel, hotels, physician services and the like to collapse. Containment policies predominantly affected the services sector, pulling prices of services down far more than the prices of physical goods.

Shelter-in-place policies immobilised workers which invariably disrupted the supply chain, dragging the production of goods and services below full capacity in certain sectors. The fall in supply exerted upward pressure on price but demand effects dominated overall, precipitating a general decline in prices in 2020.

Incoming inflation data on a 12-month basis in the next few months may appear extraordinarily high as the low March and April price readings from last year drop out of the 12-month calculations. High inflation data in this case, is more noise than a signal as it is primarily the result of an arithmetic quirk as opposed to the long-term trajectory of prices. Federal Reserve officials have noted that these calendar effects do not matter much in the way of policymaking. What they are keen to monitor is sustained improvement in inflation, rather than transient, one-off spikes. Nevertheless, inordinately high inflation data could trigger a scare in financial markets.

The commodity super cycle

Rising commodity prices as the global economy climbs out of the pandemic-driven rut have also added to inflation worries. The Bloomberg Commodity Index, which tracks a variety of commodity futures prices, has already risen above pre-pandemic levels, in a way reflecting buoyant expectations of a robust recovery of global demand. Continued stimulus support, supply shortages due to under-investment in 2020 and a global movement to “green” infrastructure may continue to buttress the upswing in commodities.

Indeed, we may be in the cusp of a commodity super cycle that could possibly play out through 2021 and 2022. Typically, commodity prices tend to closely track actual headline inflation. Consequently, higher commodity prices may well portend higher inflation ahead as it takes time for such resource price effects to appear in the prices of final goods and services.

Too much money chasing too little goods

In addition, massive quantitative easing by major central banks and record fiscal deficits by governments in developed economies are also fuelling inflation concerns. The explosion of central bank balance sheets since the onset of the Covid-19 crisis has resurfaced concerns about too much liquidity chasing too little goods, as central banks print record amounts of money to finance the purchase of financial assets like government bonds and private credit. Inflation fear mongering is not new – the same was said would happen post the financial crisis when central banks expanded their balance sheets and introduced quantitative easing. Yet, low inflation – not high inflation – has been the main bugbear for policy makers over the past decade.

Meanwhile, concerns over fiscal policy revolves around the timing and size of the stimulus package, and what it means for aggregate demand. Inflation seers typically narrate a familiar story outlined below.

Rise of the supercharged economy

Favourable Covid-19 trends

From the outset, the Covid-19 crisis is not an ordinary recession. It is akin to a negative shock, where the economy is forced into hibernation as governments rush to contain the virus. Social distancing policies coupled with general fears of the virus have led to deferred consumption and investments, as people and businesses become more cautious about spending and investing amid heightened uncertainty. Ultimately, the pace of the economic recovery hinges on developments on the virus front. Normalcy can only return once it is safe to conduct economic activity.

The good news is the worst of the pandemic is largely behind us, as Covid-19 vaccination efforts ramp up while infections, deaths and hospitalisations exhibit a firmly declining trend. The seven-day moving average of Covid-19 infections has fallen below 71,000, from a peak of more than 280,000 in January this year. Meanwhile, daily inoculations average about 1.6 million, with 35 million Americans having already received their first shot. This represents about 10% of the entire US population.

According to the World Health Organisation, a range of about 60% to 70% of the population has to be vaccinated in order to achieve herd immunity. Dr Anthony Fauci, chief medical adviser to President Joe Biden, has incrementally moved up the goal post to about 75% to north of 80%. Whatever the actual figure is, should these favourable infection and vaccination trends continue, most estimates suggest that herd immunity may be well within reach in the second half of the year.

The risks to this outlook include the emergence of new strains of Covid-19 that are more virulent and resistant to the vaccine as well as vaccine production shortages and executional risks related to vaccine distribution. As it is, the winter storm moving through Texas has already stalled vaccination efforts.

Lifting the flood gates of pent up demand

On the other side of the crisis, is a supercharged economy that is expected to record booming growth once the Covid-19 pressure valves are removed. Growth is expected to be robust enough that it pushes the economy past full employment and ignites high inflation. At least that is the expectation as inferred from the rapid ascent in long-term treasury bond yields.

This is a possibility, as there is plenty of pent up demand for services that were curtailed because of social distancing policies. These activities include eating out at bars and restaurants, going to the cinema, travelling and engaging in other face-to-face leisure pursuits. Understandably, spending on services remains depressed, while spending on goods have exceeded pre-pandemic levels as consumption merely shifted from offline to online channels. One could therefore expect that relaxation of social restrictions and the reopening of businesses once Covid-19 recedes could open the dam of deferred of consumption and pent-up demand, especially for services.

The spending surge will likely be driven by middle- and high-income households with ample financial firepower to unleash such pent-up demand. As it is, households have accumulated savings balances of over US$2 trillion, representing about 10% of nominal US GDP. This substantially exceeds the pre-pandemic 5-year average of about US$1.1 trillion. In addition, the household savings rate remains elevated and has not fully declined to levels that prevailed before the pandemic hit. The higher savings rate mostly reflect cutbacks on spending on discretionary services that were curtailed due to containment policies as well as income windfalls from direct stimulus payments to households from previous Covid-19 financial relief packages. Indeed, thanks to these stimulus cheques, personal household income actually grew in 2020. Once the hurdles for consumption are fully lifted, one could expect consumer confidence to return and spending to increase at an unprecedented rate, especially as households draw down their elevated savings.

The sudden surge in demand for services may well outstrip supply. The closure of many small businesses that were not able to sustain operations due to heightened Covid-19 related uncertainty and under the weight of prevailing social distancing measures necessarily damages the supply side, reducing overall production capacity. A smaller number of players servicing record levels of demand may result in margin expansion across the services sector, as it takes time for new businesses to enter and absorb some of that demand. Widening margins in this case necessarily lead to higher prices, and since services typically accounts for the bulk of personal consumption expenditure, this should translate into higher inflation on a 12-month basis.

Then there’s fiscal policy

Economic growth is further buttressed by firming prospects of substantial fiscal support by the Biden administration. As it stands, the Democrat-controlled Senate is prepared to push through Biden’s US$1.9 trillion American Rescue Plan via the budget reconciliation process. Among the keystrokes of Biden’s plan are an extension to the enhanced unemployment benefits and eviction moratorium as well as direct payments of US$1,400 to most American households. Through this procedure, fifty Senate Democrats will be able to pass the bill on partisan lines, with Vice President Kamala Harris wielding the 51st tie-breaking vote.

Of course, this requires all Democrats in the Senate to play ball, which is not a guarantee. Centrist or conservative Democrats like Joe Manchin of West Virginia and Kyrsten Sinema of Arizona will have immense leverage in this political process and may wish to whittle down the price tag, although not to the extent of the Republican’s US$600 billion proposal. The final bill should not veer too far from President Biden’s initial plans. The passage of such a significant fiscal bill may be ill-timed if the US economy returns to normal by the second half of this year as the Covid-19 threat recedes. The boost to aggregate demand, alongside the surge in consumer spending, might elevate the risk of sustained post-Covid-19 inflation.

Democratic lawmakers are also keen to follow up with a second discretionary fiscal package tackling infrastructure investments and climate change related spending later this year. This will provide yet another tailwind for growth and may exacerbate the risk of higher than expected inflation.

You don’t just jump from recession to inflation

Many moving parts, all uncertain

Yet, inflation naysayers are quick to point out there is a great deal of uncertainty about how things will play out. Inflation may be a real risk if the economic narrative spelled out above plays out largely to script. However, this hinges on many things going right, not least among them being that the Covid-19 threat is surmounted by the second half of the year.

Indeed, it might be a little too presumptuous to think that consumers will immediately unleash pent up demand all at once when it is finally safe to do so. It may still take some time for households to feel confident enough to spend again and even so, they may choose to smooth out consumption over time as opposed to front-loading spending.

Much also depends on the roll out of vaccines across the US. As mentioned earlier, production shortfalls, execution risks and the emergence of other more virulent and potent strains of Covid-19 may complicate vaccination efforts. It is a massive logistical undertaking after all. Despite recent favourable infection and vaccination trends, Dr Fauci noted in a recent interview that normal life may still be some way off and expects “a significant degree of normality” to return much later in the year, possibly by fall and winter.

You probably won’t spend much if job prospects are weak

Even if Covid-19 recedes, the response of consumer demand is also contingent on the strength of the labour market. Labour market fragility may keep savings rate high as households focus on beefing up liquidity buffers to ride out a period of uncertainty. After all, people will only be willing to spend additional funds if they have certainty that their livelihoods are on solid ground.

As it stands, recent data point to a tenuous labour market recovery. There is plenty of slack in the labour market as the unemployment rate continues to hover at rather high levels, even if it has recovered from Covid-19 peaks. According to Fed Chair Jerome Powell, the real unemployment rate in the US, after adjusting for misclassification errors, is closer to 10%. For context, the unemployment rate peaked at 10% during the Global Financial Crisis. The recent tick up in initial jobless claims has also added concerns about the recovery. Meanwhile, the labour market participation rate has ticked lower, as discouraged workers abandon the job search and exit the labour market, likely reflecting concerns about the paucity of jobs in the current economic environment. In a recent speech for the Economic Club of New York, Mr Powell also noted that “the pandemic has led to the largest 12-month decline in labour force participation since at least 1948.”

Notably, the US economy has not regained all the jobs lost at the height of the lockdown in April last year, falling short by about 10 million jobs. For context, at the height of the crisis last year, 20 million jobs were lost. At the same time, many of these job losses are permanent, which means they will not reappear even when economic normalcy returns. A sluggish recovery of the labour market could push consumption growth further out into 2022, although it is difficult to argue that this would be a prolonged process, especially with firming prospects of fiscal policy adding fuel to demand.

Shape and price tag of the stimulus plan still uncertain

Still, the political machinations underpinning the passage of Biden’s Covid-19 relief plan remains uncertain. While a Democrat-led Congress almost guarantees the passage of fiscal stimulus, the final form and sticker price of the bill is still up in the air.

For our part, we are partial to the argument that it is not a straight road ahead for inflation. Inflation will likely be contained in the short-term by slack in the labour market. As the economic recovery firms, inflation risks merit monitoring.

WWFRD: What will the Federal Reserve do?

The upshot is inflation is expected to rise in 2021, but whether it can be sustained into 2022 remains uncertain. For now, inflation is a problem insofar as what it implies for monetary policy. Investors fear that a booming, roaring twenties-like set-up will push the economy past its full employment threshold and stoke undesirably high inflation. It follows that the Fed will withdraw policy support and hike interest rates, damaging the very foundations that spurred the rally in risk assets in the first place.

Yet, such concerns are missing the point of the Fed’s recent shift towards an average inflation rate targeting policy regime, in which the central bank has credibly communicated a willingness to tolerate a period of higher-than-2% inflation to compensate for prior inflation shortfalls amid a decade or so of unsuccessfully fighting undesirably low inflation.

At the same time, the Fed is also willing to stomach a hot labour market, as research shows that a tight labour market tends to extend job opportunities to a broader segment of people. For now, the Fed’s focus remains on supporting the recovery and they continue to reiterate their dovish bias. They’ve astutely kept vague the specifics of their forward guidance in terms of how much above-target inflation they are willing to tolerate and for how long, providing the flexibility to adjust policy.

Should inflation present a problem, the Fed has the tools necessary to correct the issue. But after a decade of below-target inflation, it seems awfully premature and a leap to think that runaway inflation will be next logical problem the economy faces, especially when the economy is clearly not functioning at full employment and that the normalisation process will take time. Other secular trends such as the rapid adoption of technology during this pandemic, ageing population and the like may dampen long-term inflation pressures as well.

Of course, the scale of fiscal and monetary stimulus this economic cycle is truly unprecedented, and few can predict what this means for the trajectory of general prices, as there’s no past lessons to draw from. Even the scale of the global pandemic is not one we have seen in well over a hundred years. Yes, there is a risk inflation could become intolerable, but it seems too premature to make this call so soon. It’s akin to putting the cart before the horse.

We’re not there yet

To be clear, concerns about high inflation and policy withdrawal by the Federal Reserve seem somewhat premature. In the near term, ‘base effects’ pushing inflation rates up over the next few months may cause market jitters. However, the Fed is likely to remain dovish and look through these temporary overshoots in inflation above its 2% goal, with their focus sharply on supporting the stalling labour market recovery. As detailed earlier, the slack in the labour market should keep inflation from escalating out of control. As such we expect the Fed to leave the Fed funds rate at 0.00-0.25% range until as late as 2024 or 2025. We therefore do not see a rise in inflation this year causing a broader shock that hurts financial markets by the way of sharply increasing bond yields.

Even at current levels, real interest rates – the difference between 10-Year US Treasury yields and 10-Year breakeven rates (inflation expectations) – remain firmly negative which should continue to benefit risk assets. Nevertheless, investors should still engage risk assets prudently as stretched valuations and potentially frothy asset markets may be vulnerable to corrections on speculation that the Federal Reserve may unwind its extraordinary monetary policy support as well as rising long-term interest rates.