Inflation — more enduring than transitory
The May 5, 2021 U.S. inflation print confirms what we have been saying since the start of the year — inflation was going to spike — and spike it did. Headline inflation came in at 4.2% year-over-year (YOY) while core inflation (ex-food and energy) came in at 3.0% YOY. The U.S. 10-year Treasury yield has added 4 bps to 1.66% as I write this. The headline number was well above expectations of 3.6%.
Notes coming out this morning centre around the fact that one of the key drivers of inflation was used cars (no pun intended) and may itself be an example of transitory inflation. While this may be true, we believe there are other forces that will continue to contribute to higher inflation through this year, including: commodity prices, an increase in consumption from pent-up demand and excess savings, a strong housing market (read: consumption cycle), and wages.
Our stance remains the same. While a significant jump in inflation (to 4%) has emerged in April, it’ll continue through June and is largely as a result of base effects (very low price levels a year ago transitioning to high levels today). However, we further believe higher inflation (a level above 2.5%) is here to stay. Our inflation model, which accurately accounted for an inflation peak in April, suggests that while the Consumer Price Index will moderate in the coming months, it’s likely to remain above 2.5% through 2021. We believe we’re using conservative estimates for our forecast inputs and, as such, the risks to inflation may lie to the upside.
We believe the U.S. Federal Reserve, meanwhile, is stuck between a rock and a hard place. In the last scenes of Animal House, Kevin Bacon’s character (Chip Diller) is standing in front of the rioting crowd, hands up, yelling, “Remain calm! All is well!” Is Fed Chair Jerome Powell having his Chip Diller moment by repeating the transitory inflation story? Perhaps.
There are many economists and investment strategists who believe as we do — that inflation over the next year or two is going to trend higher than we’ve seen in the last ten. Again, our expectation is that while April may be the peak, headline inflation is likely to trend above 2.5% through the remainder of this year. The challenge that the Fed faces is that to acknowledge higher inflation today may spook the bond markets and, in kind, the equity markets. Powell likely doesn’t want to be the one to be the cause of a bond and equity market sell-off. So, the more conservative tactic may be to hold to the transitory story until the data is irrefutable. At that point, the market may have accepted and priced in the higher inflation environment, allowing the Fed to follow suit with a shift in monetary policy.
We don’t believe that the environment warrants the Federal Reserve to start raising rates in 2021. But we believe the back half of 2022 is on the table. Until then, we expect the U.S. 10-year Treasury yield to continue its climb higher towards 2.0% before the end of 2021 and towards 2.9% before the end of 2022. As such, we believe the yield curve will continue to steepen until the Fed starts to raise rates (which is consistent with the historical trend of the yield curve).
We continue to emphasize a short duration bias for fixed-income positions.
CPI YOY vs CMS inflation model
1998 – January 2022 (including forecast)
Federal funds rate vs U.S. 10-yr three-month spread
1971 – current
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