Some months ago, as the snow melted off the lawn, a rabbit appeared at the end of our back yard. Our twin shih tzus, Buddy and Bruiser, spotted the intruder and, barking furiously, headed off in pursuit. The bunny, having given our fearless duo a head start, then bounced off into the undergrowth, cotton-tail waving in the air, leaving them barking at each other as if to say “Where’d he go? Where’d he go?”
In the weeks that followed, there were plenty of repeat performances, always ending in the same manner. But by now, frankly, Buddy and Bruiser have surrendered. The rabbit, (or I should say rabbits as they now, somewhat ominously, appear in pairs), edge ever closer to our house and stare at the dogs in a distinctly taunting manner. But Buddy and Bruiser simply eye them lethargically, having given up the chase.
Bond investors seem to be regarding rising inflation in a similar manner. Recent reports have shown consistent upside surprises on measures of wages, home prices and consumer prices, culminating in last Thursday’s red-hot May CPI report, which showed a 5.0% year-over-year gain in overall CPI and a 3.8% increase, excluding food and energy. However, despite this, long-term interest rates have edged down, with the 10-year Treasury yield falling to 1.45% on Thursday, its lowest level since the start of March.
There are two broad possibilities for why this is happening.
First, it could be that investors see some weakening in the pace of recovery and agree with soothing commentary from Fed officials who assert that any price pressures showing up today are merely part of a transitory interlude before a return to stable or falling inflation.
Or, second, it could be that technical forces in the bond market are suppressing long-term interest rates, at least for now.
For investors, it is important to pay attention to this debate because if the Fed is wrong and higher inflation does indeed become imbedded into the economic landscape, technical forces should eventually subside, allowing long rates to move higher and restarting the rotation from growth to value, which has characterized much of this year so far.
Is The Risk Of Higher Inflation Really Declining?
Those arguing that inflation pressures are actually easing could point to two consecutive jobs reports that have disappointed both with respect to payroll gains and declines in unemployment. To be sure, there is nothing wrong with average job gains of 419,000 over the past two months or a 0.2% decline in the unemployment rate to 5.8%.
However, in an economy where payroll employment is still 7.6 million jobs lower than before the pandemic and the unemployment rate is 2.3 percentage points higher, this progress seems painfully slow.
That being said, healing in the job market is, most likely, just being delayed by a few months due to the remaining impact of the pandemic and relatively generous unemployment benefits. The economy continues to reopen rapidly and enhanced unemployment benefits will expire in half the states by early July and the other half by early September.
This, combined with clear evidence of extraordinary labor demand, (as confirmed by last week’s JOLTs report), should lead to a very rapid increase in employment and decline in unemployment over the next six months. In the meantime, wage growth has clearly accelerated and this should continue to add to inflation pressures into 2022.
In addition, further fiscal stimulus looks likely before the end of the year, composite PMI data show global economic activity accelerating at its fastest pace in 15 years, and West Texas Intermediate Crude oil prices closed out last week at over $70 per barrel for the first time since October of 2018.
Mapping all of this into our economic models suggests inflation in the fourth quarter of between 3.5% and 4.0% year-over-year as measured by the personal consumption deflator, which is the Fed’s favorite inflation gauge.