The Inflation Boogeyman is a Myth
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What You Missed Last Week: Long-term interest rates consolidated, falling from recent highs, while equities traded in record territory as the US economy showed continued signs of recovery and earnings reports largely beat expectations. Despite very strong data, which would usually imply higher interest rates, the yield on the benchmark US 10-year Treasury note declined 13 basis points to 1.57% amid reports of renewed overseas buying, particularly from Asia. Short-term rates continued to drift near all-time lows. The price of a barrel of West Texas Intermediate crude oil rallied about $4 to $63.35, and the US Dollar weakened, and Gold strengthened. Treasury yield volatility, a key hidden driver of the cost of rate caps and swaptions, fell steadily throughout the week.
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Parade of blowout data shows America’s shift into a higher economic gear – how long will it last? After being disrupted by rough winter weather in February, America’s economic pace quickened in March. Retail sales surged 9.8%, weekly jobless claims fell below 600K for the first time since the onset of the pandemic and regional Fed manufacturing surveys from New York and Philadelphia showed strong upticks. The inflation boogeyman reared its ugly head too, with the Consumer Price Index rising 2.6% at the headline level and 1.6% stripping out food and energy. Bottlenecks in the production cycle will continue while YOY data comparisons feed through to inflation readings in the coming months.
Our take: The overall tone from the latest round of data releases signals a swift reopening of the economy is indeed at hand. However, like we said last week, don’t let the blowout numbers fool you into thinking that early positive growth numbers will push inflation – and interest rates – notably higher over the long haul or that we’re in the midst of a growth wave in excess of where we’d be had the pandemic never happened.
In our opinion, there is little utility in drawing conclusions from comparisons of economic data from the current fiscal stimulus-soaked economy entering the fastest quarter of growth since 1978 against the record deep recession of a year ago. The comparisons will only get starker (and less useful) in the coming months. The same logic should also be applied to signals implying that inflation is rising to any worrying degree. Consumers – who alone are responsible for ~70% of US economic activity – are indeed seeing higher prices at the pump and some reacceleration in prices for both goods and services. Is it indicative of higher inflation? No.
Economic activity and the labor market are vigorously rebounding, but rising prices are a mere reflection of post-pandemic stabilization rather than sustained reacceleration. What could drive prices notably higher on a sustained basis is only one thing: higher wages. Consumers wages have been stagnant for years, and the underlying dynamics of the jobs market – where almost nine million people are still unemployed when compared to the start of the pandemic – implies that we will not see any real change in wages and by extension, in the inflation picture until the excessive labor slack is mostly reabsorbed. If you want to get a sense of where rates are headed in the long term, look no further than the jobs market.
While its certainly true that overall inflation is moving higher – look no further than elevated demand and localized supply-chain disruptions creating price spikes – it’s only a moderate acceleration for the time being. The Fed agrees – it has said repeatedly that it will look through these so-called “base effects” in deciding when to take away the easy-money punch bowl.
Think LIBOR’s transition to SOFR is a done deal? Think again. Zions Bancorporation (NASDAQ: ZION) announced its intent to adopt AMERIBOR® – a floating rate alternative to SOFR – as a replacement index for LIBOR for the largest portion of its non-syndicated commercial loans currently indexed to LIBOR. Many regional and community banks have real issues with SOFR – specifically that it does not contain a credit component and that there is only a nascent forward curve at present – prompting them to seek alternatives to LIBOR’s anointed replacement. Why you should care: At the end of the day, the post-LIBOR lending world could be made up of a spectrum of floating rate indices, AMERIBOR and Bloomberg’s Bank Yield Index (BSBY) among them, resulting in more efficient pricing of floating rate loans amid a choice of indices that better reflect a lender’s cost of funds. Are you contemplating a floating rate loan? What does the loan agreement say about LIBOR’s sunset? Get educated here.
Support for Biden’s infrastructure plan is waning. According to a CNBC poll, President Biden’s proposed infrastructure program is proving much less popular with the public than the recently passed coronavirus recovery plan. Thirty-six percent support infrastructure spending while 33% oppose. In contrast, about twice as many favor the recently passed American Recovery Plan than oppose it. Why you should care: Any delay or watering down of the plan will help erode upward momentum of long-term interest rates.
ISDA’s new IBOR fallbacks have come into effect: Are you a borrower? Do you own an interest rate cap or have an interest rate swap? It’s critical that you understand the IBOR fallbacks to avoid potentially negative financial consequences down the road. Get educated here: The ISDA IBOR Fallback Protocol and What it Means for You
China reported eye-popping Q1 growth. A peek into America’s economic future? Perhaps. Gross domestic product in China grew 18.3% in Q1 2021 compared with the same quarter a year ago, when the country was in the throes of its coronavirus lockdown. While the numbers appear robust on the surface, analysts expect that China’s fastest period of recovery is behind it and that growth will quickly moderate toward a 6% annual rate in the quarters ahead. Economists also note that seasonal adjustment data has been thrown out of whack by coronavirus restrictions, which limited the traditional movement of migrant workers to their hometowns over the Lunar New Year period while keeping historically shuttered factories in operation over the holiday.
What to Watch This Week: The communications blackout period ahead of the April 28th Fed monetary policy meeting commences this week, and the sparse data calendar is limited to new and existing home sales, as well as jobless claims. All told, it is a week that will continue to paint the picture of surging economic growth, strong job gains due to record stimulus spending, low interest rates, and the positive impact of broadening vaccinations.
Big Picture: A confluence of three strong positive factors propelled growth in retail sales in March: the latest round of stimulus checks, unwinding from the February freeze and a broader economic reopening. As businesses continue to get back to normal operations, and as the stimulus impact also spills into April, the strength in consumer activity will persist into Q2, boosting GDP growth to the highest pace in decades.
While on the surface the scenario implies higher rates, we saw long-term rates consolidate last week after blistering spikes in recent weeks. However, consolidations are never more than a pause in the longer-term trend, and we stand by the view that the 10-year Treasury yield will edge toward 2% by year’s end and rise to 2.25% or so before the Fed acts to reign in monetary stimulus at some point next year.
For now, the current 1.52% to 1.73% range in the 10-year Treasury yield will likely hold until the market is comfortable reassessing the growth outlook as the economic boost from fiscal stimulus fades. Over the mid-term, the bias is for long-term rates to continue their move higher.
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Source: Bloomberg Professional
Source: Bloomberg Professional