The Inflation Scare
What exactly are we afraid of? It was always a safe bet that there would be an inflation scare at some point early this year. Just the base effects caused by the shutdown and the dive in the crude oil price 12 months ago more or less guaranteed that year-on-year comparisons would look scary for a while. But the scare has already started, at a point when actual figures don’t look alarming in the slightest. This is Wednesday’s reading for core U.S. consumer prices (excluding fuel and food). It was slightly lower than expectations:
As for the official market view, five-year breakevens have moved up to 2.5%. As the Federal Reserve wants inflation to run above 2% for an extended period, this is outright good news. Meanwhile five-year five-year forward breakevens suggest that the market is expecting prices to cool in the years from 2026, and average almost exactly 2%. That suggests positive reflation over the next few years, but not a return to a true inflationary regime and psychology:
Meanwhile, real yields remain negative. After a sharp rise in February, enough to have an effect on other markets, the U.S.10-year real yield has declined again. Its trend still appears to be upward, but it is hard to call this a serious tightening of financial conditions:
If central banks do anything about this, it will be to try to put a thumb on the scale to push bond yields down again. Thursday’s meeting of the European Central Bank has been preceded by much speculation about what actions the ECB might take, even though 10-year German bund yields remain firmly negative in both nominal and real terms.
So where does the alarm come from? And where would inflation itself come from? The longer-term arguments rest on demographics, and in a historic shift in the Fed’s priorities, to match the change in population trends and central bank priorities that ushered in the age of declining inflation 40 years ago. For long Points of Return discussions on these topics, see here and here. These arguments have to contend with the fact that improving technology has acted as a deflationary force for decades, and will probably continue to do so.
These ideas are swirling around the investment world. But what has really driven the stock market rotation in recent weeks isn’t a fear of inflation so much as a swift rise in bond yields. In the short term, this might engineer a selloff—but that is due to the mathematics of leveraged investing, rather than the discount rates for future cash flows.
Tom Tzitzouris of Strategas Research Partners suggests that stocks have avoided an overall selloff because yields have barely touched what he describes as the “danger zone.” He defines this using a “fair value” metric for yields which I covered earlier this year. On this definition, fair value is the expected cost of carry, which should generally be close to the consensus expectation of the neutral fed funds rate over 10 years. Tzitzouris’s model posits that a danger zone is reached when the the actual yield exceeds this fair value by 15 basis points or more. And the market has shown a remarkable ability to flirt with that zone so far this year without going significantly far above it:
