Before the Bell: Reflation concerns prompts yields spike while UK CPI is up next
Over the past few weeks, it’s been notable that bond markets, both in the UK and in the US are starting to price the risk of higher inflation pressures, as long-term yields move to the upside.
Yesterday, US 10-year treasury yields jumped sharply higher to 1.3 per cent, in a move that suggested that markets were either starting to become increasingly concerned about inflation risk, or more confident about an economic rebound, depending on your narrative
This move higher in yields, unsettled equity markets as the day wore on despite new record highs for US stocks, with the result, that after an initially positive start markets in Europe and the US slipped into negative territory, and closed marginally lower on the day, explained Michael Hewson, chief market analyst at CMC Markets UK, this morning to City PM
“Combined with sharp rises in energy and commodity prices, there is rising concern that higher prices will not only choke off any post pandemic recovery, due to higher borrowing costs, but they could also crimp future consumer spending due to higher living costs,” he said.
This caution appears to be manifesting itself into this morning’s European open, which looks set to be a mixed one, with Asia markets also trading in a similar fashion.
Here in the UK, since the beginning of this year we’ve seen UK gilt yields rise from lows near 0.17 per cent to be trading above 0.6 per cent, Hewson pointed out, adding that this is quite a significant move in the wider scheme of things, especially when short term 2-year yields are still negative.
“This move in rates reflects a sharp rise in market inflation expectations, in response to the large-scale fiscal stimulus which is expected to get unleashed in the coming months in the US, as well as a lesser extent here in the UK,” he said.
“We’ve also seen sharp rises in commodity prices, notably copper and crude oil, both of which have moved sharply higher since the beginning of this year, with oil prices up over 20 per cent year to date,” Hewson continued.
CPI numbers
This rise in inflation expectations has for now not been reflected in higher headline CPI numbers, and probably won’t be for several months. However Hewson is convinced that could well start to change over the next few weeks, while consumers will notice straightaway when they go to fill their cars up when lockdown gets eased.
“In recent months headline CPI numbers have fallen below the radar a little, however given the sharp rise in 10-year yields since the start of this year in the US, as well as here in the UK, fears over a sustained rise in inflation is starting to stalk the markets,” he noted.
“This rise in prices isn’t expected to manifest itself in today’s January numbers, however the headline CPI numbers could start to get more interesting as the year progresses. Expectations are for UK inflation to slip back to 0.5 per cent from 0.6 per cent with core prices also set to decline to 1.3 per cent, from 1.4 per cent.”
The place we might start to see inflationary pressures build up is in factory gate prices, Hewson pointed out, adding that, for now, these still remain “fairly benign,” however input prices have been rising for several months now from negative lows of -4.6 per cent in April last year, with an expectation of a rise of 0.6 per cent in January.
“It’s a similar story for output prices, though they are still expected to remain negative at -0.4 per cent.”
UK economy
While the UK economy is likely to see consumer spending weaken in January, the US economy is set up for a rebound with their latest retail sales numbers for January which are due to be released later today.
After a decent recovery in the aftermath of last year’s April lockdown US consumer spending saw a fairly strong rebound as US consumers spent their stimulus cheques, giving the economy a decent lift through Q2 and Q3. This growth started to slow quite markedly in Q4, Hewson noted, as the expiry of certain unemployment benefits, uncertainty over the US election, along with the imposition of tighter coronavirus restrictions started to weigh on consumer confidence.
This consumer slowdown along with the political deadlock on Capitol Hill over a stimulus package saw retail sales in November and December slide back quite sharply, by -1.1 per cent and -0.7 per cent, respectively.
“Since then, the economic data has picked up markedly, helped in some part by the new $900bn stimulus plan that was agreed at the end of last year, and expectations over another $1.9trn later this quarter,” Hewson said.
“This optimism is likely to translate into a rebound in consumer confidence and ergo a possible rebound in consumer spending, after a disappointing Thanksgiving and Christmas spending period. Expectations are for a 1 per cent recovery to start the year, which could well continue into the rest of Q1,” he added.
FOMC today
Today’s FOMC minutes are likely to be somewhat dated given recent events, nonetheless they could well offer an interesting insight into some of the discussions that took place around the risks of a sharp rise in inflation.
“The context for is because in the lead-up to the January Fed meeting we heard from the likes of several Fed officials including Raphael Bostic of the Atlanta Fed who suggested, in contrast to the December messaging of lower for longer, that we could well see a taper of the $120bn monthly asset purchase by the second half of this year, and a rate hike before the end of 2022,” Hewson observed.
While Fed chief Jay Powell, along with vice Chair Richard Clarida clamped down on this messaging at last month’s meeting, these concerns haven’t gone away given the prospect of another large stimulus program, and a US economy that looks more resilient than some of the recent data might suggest, he continued.
“At the press conference Powell was keen to stress that the recovery was still fragile, and a little weaker than had been the case in December, nonetheless concerns about higher prices weren’t particularly elevated in the short term,” Hewson noted.
His comments – that the Fed was prepared to tolerate inflation above 2 per cent for some time – suggests that they might be prepared to look past any short-term inflation pressures. This does appear to being reflected in bond yields, with the short end fairly steady, however long-term inflation expectations are rising quite sharply.
“As such it will be interesting to note whether the concerns articulated by some FOMC members in early January got an airing in the broader discussions, around what might happen if inflation pressures did start to accelerate beyond what members of the committee might be comfortable with,” Hewson concluded.