BlueBay AM: CPI hits 5% but Fed intent on inflating further

11 juni 2021

Mark Dowding, CIO at BlueBay Asset Management, has issued his latest market commentary. This week, he focusses on inflation, tapering and renewed Brexit-related trade concerns.

Notwithstanding another strong US CPI report, Treasury yields declined over the past week, supported by the notion that price pressures are transient and that inflation numbers may now have peaked. We continue to believe that this market reaction remains very complacent. US headline prices are up 5% year-on-year with core prices rising by 3.8%. This marks the strongest inflation print since 1992 – a time when 10-year yields were above 7.5%.

Gains in car prices and airfares were partly to blame, though it is interesting to note how inflation may now be starting to feed into behaviour and expectations. The Jolts survey of US job openings stands at a record high of 9.3 million jobs – up more than 3 million since the end of 2019 before the pandemic struck.

With non-farm payroll job gains running at a more modest pace in the past couple of months, it is tempting to read into the data that workers are holding out for higher wages. This appears to be supported in hourly earnings data and the fact that generous benefits are driving the de facto minimum wage above USD 15 per hour.  

The US economy still needs to add another 4 million jobs to get back to full employment, but the growth outlook remains robust.

The Atlanta Fed growth Nowcast is running around 10% for the quarter and we remain confident that the economy can continue to move ahead at a brisk pace through 2021 as economic re-opening post-Covid coincides with fiscal and monetary policies, which remain super accommodative. 

Indeed, we are starting to wonder whether some on the FOMC may be growing a little more uncomfortable with the inflation dynamic they are witnessing. At the March FOMC, the Fed lifted its projection for PCE inflation at end-2021 from 1.8% to 2.4%. However, another substantial revision towards 3% would seem merited, in our opinion.

We believe that it remains too early to expect a change in rhetoric at the Federal Reserve meeting next week, but we may only be one or two decent job prints away from taper discussions coming to the fore.

We continue to look for a debate to kick off in earnest at the August Jackson Hole meeting and taper to be announced in September. In that context, we see the outlook for yields skewed to the upside over the summer and continue to hold a short US duration view with a relatively high level of conviction.

Europe

In the eurozone, this week’s ECB meeting passed without much event, as Lagarde presented a narrative little changed from April’s press conference.

Relative to the US, the fiscal policy response in the eurozone has been designed to be more back-loaded, whilst delays in the vaccination programme have meant that the continent is lagging in its ability to ease COVID-19-related restrictions and re-open the economy.

However, progress in the right direction is now palpable and we project a stronger economic performance in the eurozone in the second half of 2021. This is consistent with ECB staff projections, with growth and inflation estimates ratcheted higher for 2021 and 2022 for both growth and inflation. This being the case, we expect the Governing Council may decide to reduce the pace of PEPP purchases in September, in sync with when we expect the Fed to commence its taper.

In Europe, we believe that when the taper announcement comes, it may coincide with a decision to extend the PEPP by a number of months, such that there is not a hard stop in March 2022. We believe that an extension to June, or beyond, is likely in order to ensure that the taper can be a smooth and gradual process, without the need to add to the current volume of PEPP that has already been announced.

UK

Rising infections in the UK seem to be causing policymakers to question the planned easing of restrictions on 21 June, amid concerns regarding the Delta variant. 

With over 80% of adults in the UK now having COVID-19 antibodies, one may wonder why the government is prevaricating, unless it has come to the conclusion that vaccines are not working. 

Clearly, this would be a very troubling development, but there seems little evidence to suggest this. Rather, it would seem that the government is observing that taking a cautious approach and pushing a message of fear is serving it well in terms of the level of support the Tories currently enjoy. It seems that a sizeable minority are largely content sitting at home and receiving state support. 

Looking through political history books, it is striking to note that in past times, when societies had surrendered their freedom and liberties to the ruling powers, this process is slow to reverse. One gets the sense that many in government are delighting in the power of controlling individuals’ day-to-day lives, and the proletarian mass are either too scared or too lazy to do too much about this. 

Notwithstanding this, it strikes us that there may be too much optimism around UK relative economic performance in 2021. 

This may also be compounded by the risk of a simmering trade dispute with the EU relating to sausages and the implementation of the Northern Ireland protocol. The Brexit agreement created a border in the Irish Sea and it always seemed clear that this was going to risk an upturn in tensions in the Province, with Unionists aggrieved as a result. 

The UK government may find itself needing to risk violence in Northern Ireland if it wants to avert trade troubles with the EU (and conclude a trade deal with the US). Westminster will want to blame conflict on Brussels, but ultimately it was the UK government that signed the Brexit deal, hence any blame should sit closer to home. 

Nevertheless, this is a risk that could escalate over the summer months and a reminder that Brexit is now behind us, but still a factor that can weigh on UK prospects.

Market round-up

Elsewhere, the newsflow has been relatively quiet. Buoyant equity markets have seen measures of implied volatility dropping in a summer lull and this has helped credit spreads grind tighter, but without much directional impetus. 

Emerging markets have benefited from the move lower in core rates, with indices now recouping many of their losses from earlier in 2021. 

FX markets have remained relatively quiet over the past couple of weeks, whilst crypto has continued to witness relatively erratic price action following concerns that it may become subject to greater scrutiny and regulation in months to come.

Meanwhile, commodity markets have resumed gains, with oil breaching USD 70 per barrel. 

Pressure on lumber appears to be easing, though supply/demand conditions remain tight in a number of markets, with chip shortages showing little sign of easing with Taiwan producers seeing a loss in production due to renewed COVID-19 restrictions.

Looking ahead

We think that robust inflation numbers have the potential to make next week’s FOMC meeting more interesting. One wonders how hard the FOMC will want to push the narrative that price gains are only transitory, when it seems it could afford to take a slightly less dovish stance given that 10-year bonds are more than 20bps below their March highs. 

It has been interesting to see central banks move to taper bond purchases. With Yellen at the Treasury also flagging higher inflation and higher rates earlier this week, there doesn’t seem too much for the Fed to gain by trying to remain closely wedded to the existing rhetoric. After all, if central bank policy is to be reactive and data-dependent, then it is hard to ignore out-of-hand data just because it may not suit one’s current preference.

Meanwhile, it seems to us that other markets will take their cue from yields. If rates remain benign, volatility could drop even further and we may see more of the same in risk assets over the course of the next couple of months. 

However, if there were a slightly hawkish Fed surprise, or yields were to start to climb regardless, then this could act as a potential catalyst for a market retracement. That said, if the FOMC meeting delivers little new news, it is hard to see much of a catalyst for a material move in yields over the remainder of the month.

For now, it seems that markets are happy to put their full trust in global central bankers at a time when politicians are struggling with dented poll ratings as we emerge from the pandemic.