MUNIX COMMENTARY – 10 June
The balance of supply and demand means higher prices, for goods, services and bonds
It is often interesting to see how financial markets react to economic statistics – was the news better or worse than expected, is it likely to have a material impact on policy decisions?
Last week’s employment report for the US economy in May was a classic example of a non-event. Despite a plethora of figures for the markets to digest about unemployment, hours worked, and wages, the moves in US bond yields and the dollar were minimal on the day itself. The big picture was an economy slowly recovering towards full employment, with wage gains only running about 3% and total employment costs up about 4% year on year, so no great concerns as long as productivity remains strong during the recovery phase of the economy.
At face value, the US inflation report for May should have had a marked impact. The rise in headline inflation was at the top end of market expectations; CPI at 5% pa was a 13 year high. There have been rather unusual circumstances in various sectors and industries, for example used cars are 7% more expensive than a year ago as households put stimulus cheques to work. Hence, core inflation excluding food and energy was 3.8% pa, the highest since 1992. With so many one-off factors affecting the inflation report, amidst noticeable changes in consumer spending patterns, attention may turn more towards trimmed mean measures, which remove the extremes of price increases and declines.
Investors can also see more inflation coming down the line. China has recently reported its inflation data for May, with the prices of raw materials growing by 9% year on year, the fastest for 12 years. Indeed, the authorities were already rather worried about such developments, for fear of a squeeze on company profits. At the end of May, the National Development and Reform Commission had announced a crackdown on commodity price speculation.
Despite such news, the market reaction to the ‘shocking’ US inflation report was modest rather than major. Any moves on the day need to be seen in the context of a rather interesting trend. Despite a flurry of warnings from economists about the potential for inflation to jump, the market backdrop has been steady purchasing of US government debt in recent weeks. The 10-year benchmark bond yield has declined to a little above 1.5%, the lowest level in about 3 months, and the yield curve has flattened, with a decline in future inflation expectations embedded into markets.
There are various arguments to explain such movements. Some are technical. The US money markets and banking system are flush with cash, partly in response to Fed QE, and some capital will be diverted into higher yielding assets. It may be the case that a sufficient number of investors are convinced by the Federal Reserve’s argument that inflation will be a transitory phenomenon, declining into 2022 as the supply side of the economy eventually catches up with demand. Some forecasters suggest that the peak of the economic recovery will be seen by the late summer, taking account of the latest efforts by the Chinese government to restrain economic growth. Truth be told, the outlook for US growth into 2022 is clouded at present by the on-going debate within Congress about the size of the budget deficit and infrastructure packages. Understandably, the Republicans are pushing back against ‘profligate’ Democrat spending plans on the grounds that there is already enough stimulus in the economy.
Central bankers are adept at saying nothing, ringing the changes through some set phrases. This was seen in today’s ECB policy meeting and press conference, with neutral phrases so as not to harm the tentative economic recovery or worry the bond markets. European consumer inflation has returned to its 2% target, for the first time since 2018, but the central bank continues to emphasise it will soon peak and fall back. Indeed while its latest official forecasts indicate GDP growth at 4.6% in 2021, 4.7% in 2022 and 2.1% in 2023, inflation is expected to come in at 1.9% this year, 1.5% next and 1.4% in 2023. All eyes are now on the September Board meeting, but most analysts now do not expect the ECB to begin tapering its asset purchases until Q4 this year, and then err on the side of caution.
The Fed too has kept its powder dry into the summer. Nevertheless, after the latest inflation numbers, attention will be even more focused on the next set of official speeches and prepared remarks from Fed governors. Any hints that technical changes might be made to such factors as the Reverse Repurchase Facility and Interest on Excess Reserves held by banks will attract interest, whilst tapering hints or comments that inflation might not be transitory will be front page news. Until then, US benchmark bond yields remaining about 1.5% tell their story.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making