US inflation concerns: more woe for bond market as stocks could weather the storm
There is one dominant theme in financial markets right now, US inflation and the price pressures around the world. After Wednesday’s release of US CPI data for October, US Treasury yields sold off sharply, which caused yields to rise. Yields on the 2-year Treasury note rose by an astounding 0.09%. This may not sound like a lot, but it’s a big move for the generally sluggish Treasury market and it was the largest daily jump in 2-year yields since March 2020 and the peak of the coronavirus crisis. 10-year yields jumped from 1.46% to 1.56%, exacerbated by weaker than expected demand for an auction of US Treasuries. While we could see some pullback in yields as we move into the weekend, we tend to think that higher US bond yields are here to stay, which may have a big impact on financial markets in both the short and long term.
Inflation: the details
US CPI rose 0.9% in October, over the last 12 months US consumer prices have risen by 6.2%. Price increases were broad; however, the largest contributors came from energy, shelter, food, used cars and trucks and new vehicles – essentially prices were pushed higher by commodity prices, real estate and the impact of the global micro-chip shortage. Even the core rate of inflation, which strips out volatile elements like energy and food rose by 0.6% in October compared with 0.2% in September, driven by car and truck prices, shelter, recreation costs, medical care and the price of home furnishings. This is an expensive time to live in the US, and this is being replicated all over the world right now. One quirk of this index was that the price of food at home, which is measured by the BLS, rose by 1% on the month as all six major grocery store food groups saw price increases. Other food at home rose by an even greater 1.2% in October, while the cost of eating out rose at a slightly a slower pace, up by 0.8% in October. This could lead to higher levels of eating out as we move into the holiday season, which may boost the US service sector, which is already experiencing strong levels of growth.
When will inflation stop rising?
The question now is, why are prices rising at such a fast clip, and when will this slow down? There is a chicken and egg conundrum going on here: the US consumer boosted their savings pot during the Covid pandemic, which can help them to soak up some of these inflation pressures, however, the fact that people have more money to spend is also causing prices to rise (alongside supply chain issues etc). The St Louis Fed’s data on the Personal Savings Rate is useful to try and gauge how long price pressures may last. The savings rate surged to more than 33% in April 2020 as the US consumer was forced to stay at home at the peak of the pandemic, however, in September the personal savings rate was 7.5%, which is only slightly higher than the long run average (10-years). Thus, if excess savings have helped to create this crisis, with savings falling sharply this upward pressure on prices may start to recede.
2022 and the prospect of lower prices
While we don’t want to blame the US consumer entirely for creating inflation, if demand patterns return to the normal levels, which we think will be likely as savings start to run low, then inflation pressures could ease off; although we do not think that this will happen until 2022. We believe that there will be another sharp boost to inflation in the next couple of months, as the US consumer goes on one last buying spree over Black Friday and Christmas, only to tighten their belts as we herald in the New Year. However, news on inflation means that one must look at wage data slightly differently: we must look at real wage growth, which is adjusted for inflation. Headline inflation rose by 0.9% in October, the annual rate of expansion was 6.2%, wage growth rose by a seasonally adjusted 1.3% for the three months to the end of September, according to the BLS’s Employment Cost Index. Wages and salaries rose by 4.2% for the 12-months to the end of September (the most recent data that we have available), which means that when adjusted for inflation, real wage growth is approximately -2% on an annualised basis, as prices rise faster than pay slips. This is likely to put the brakes on the world’s most powerful consumer in our view and could ease the pressure on inflation down the line.
The market impact
Added to this, because we look at inflation on a monthly and an annual basis, as we move into 2022 then the monthly comparisons are likely to fall, as we do not expect the current rate of inflation to persist into Q2 and beyond. So, the question now is, will the Federal Reserve hold their nerve, or will they bow to pressure and start to signal that rate rises are coming down the line, after backing off from this hawkish route at last week’s meeting? The financial markets certainly think that this is likely. Eurodollar futures, which measure market expectations of Federal Reserve policy, shows that markets are pricing in a 75% chance of a rate increase as soon as June 2022, and a two further 0.25% rate increases by the end of 2022. This is a pretty hawkish shift in market expectations and right now that is playing out in the dollar and in equity markets.
Stocks likely to brush off inflation concerns
US Treasury markets were closed on Thursday, which leaves little room for a major pullback on Friday. It will be worth looking out for a further rise in yields at the end of the week, as this would solidify the theme of a hawkish shift in the market’s perceptions of future Fed policy. While the bond market has taken the brunt of the impact from the shock inflation data, stock markets have mostly recovered on Thursday. The Nasdaq led the way higher, rising some 0.6% erasing some of the 1.7% decline from Wednesday. The Dow was weighed down by weaker earnings for Disney, its share price fell 6.7% on Thursday after it reported weak earnings across the board and slower streaming growth, suggesting that it is falling behind its more prolific rivals such as Netflix. Subscribers to Disney + rose by 2.1mn, to bring the total number to 118.1mn. The market had expected higher, and it makes the Disney + goal of reaching 230-260 million subscribers by 2024 harder to reach. Going forward, companies that miss earnings expectations and disappoint the market are likely to receive the Disney treatment, added to this we remain wary of the small to medium size companies on the Nasdaq, as they could get hit by rising interest rate expectations and rising Treasury yields. The S&P 500 also managed to recover some of its moderate losses from Wednesday. Overall, we continue to think that the S&P 500 remains in a decent position to extend further into record territory during the rest of this quarter. However, with inflation rising at such a fast clip, and the US personal savings rate falling sharply, the risk is that 2022 is a harder one for stocks.
Dollar shines, as bitcoin loses out to gold in battle of greatest inflation hedge
Overall, the big winners from the rise in inflation are the dollar, which has been buoyed by the sharp rise in inflation. The dollar index rose to its highest level since July 2020 on Thursday and its recent break higher suggests that we could see further gains ahead, with 97.50 and 100.00 key longer term resistance zones. EUR/USD fell to its lowest level since July 2020. It will be hard for GBP/USD to recover after breaking below $1.34 on Thursday, momentum remains on the downside and in the short to medium term, $1.3350 and then $1.3220 remain key support levels. Gold is another big winner from the surge in inflation, it is at its highest level since June, and technical indicators suggest that the precious metal could reach $1,900 in the medium term. Interestingly, Bitcoin was up only a touch on Thursday, after giving back some earlier gains to $65,400. While some have argued that Bitcoin is the ultimate inflation hedge, it is worth remembering that it is still driven by its own technical and fundamental factors, thus it may not always be reliable. Technical and momentum indicators still point to further upside for bitcoin, with $70,000 still in focus.