The inflation train is about to leave the station

“In the simplest terms, inflation occurs when there's too much money in the system. On the flip side, deflation occurs when there are too few dollars in circulation.”

– Robert Kiyosaki
“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”

– Sam Ewing

While many investors may be watching the S&P 500 Index hit a new high, we’re watching the U.S. 10-Year Treasury yield nudge higher to levels not seen since the start of the global pandemic. Year-to-date, the benchmark yield has been inching higher as investors weigh the prospects for higher inflation that’s either temporary, on year-over-year (YOY) base effects, or more persistent on an economic reopening. We believe both bond and equity investors would be well-served to pay attention to long-bond yields and their reaction to inflation over the coming months. We highlighted the risk of rising yields on inflationary pressure in our 2021 outlook:

Interest rates become a tale of two ends of the curve

  • It’s expected that inflation will be higher in 2021 due to base effects from the depths of the recession (including negative oil prices). The belief is that the increase will be temporary. Our inflation model suggests otherwise. Using conservative forecasting for our model inputs, we see a sustained period of higher inflation through 2021, with risk to the upside on a stronger economic reopening.
  • While central bankers have indicated that benchmark rates will remain at their current levels until 2023, the longer end of the rate spectrum is subject to market movement. There’s always the possibility that central banks may step in to limit how high longer-term interest rates can move; however, we believe there’s reluctance to actually do so. It’s our view that central bankers would embrace higher longer-term interest rates.
  • The consensus view is for the U.S. Treasury yield curve to continue to steepen as longer-term interest rates rise. We believe the consensus is correct in the direction but not the magnitude of the increase. Our Growth/Inflation Momentum Matrix would suggest that in the 2021 environment of accelerating growth/inflation, we typically see an average increase in the 10-year yield of 50 bps with a standard deviation of 100 bps. Therefore, our non-consensus view is that rates will rise further than markets expect. We believe higher inflation will put pressure on bond yields and equity valuations, and is one of the key risks worth watching in 2021.

The Consumer Price Index (CPI) for January rose 1.4% on a year-over-year basis while core CPI (minus food and energy) showed the same gains at 1.4% YOY. Both measures were reported slightly lower than expected, according to a Bloomberg survey. Long-bond yields backed off as a result of the slightly softer CPI result. Nonetheless, we believe January’s number may be the last before we see what’s, in our view, the start of higher U.S. inflation through 2021.

Our inflation model would suggest January’s CPI result may be the low point of the year. And while the sharp year-over-year shock in inflation will come between March and May, with the potential for above 3% inflation, our work would show that higher inflation over the course of the full year is sustainable. Our rapid reopen thesis prices in modestly higher oil prices and higher wages into inflation as the global economy starts to reopen and competition for skilled labour starts to heat up again in the back half of 2021. We believe that as investors realize that the increase in inflation is real, sustainable, and meaningful, the U.S. 10-year Treasury yield will continue its ascent to our target of 1.50% (with upside risk to 2.0%) over the next six to 12 months.

This chart compares the percent change of the year-over-year Consumer Price Index to the Capital Markets Strategy team’s inflation model, from 1998 to 2021, including a forecast for the remainder of 2021. There’s a strong correlation between the two elements.

Beyond our inflation model that forecasts higher inflation through 2021, we note other data that indicate the inflation trend may continue. In particular, the National Federation of Independent Business survey shows a net 17% of U.S. small businesses raised prices in January. Twenty-eight per cent of small businesses plan to raise prices in the coming three months. The current rate of price increases and plans typically coincides with inflation (CPI) around the 2% range. Should demand increase in our rapid reopen thesis, we believe businesses will continue to move prices higher. Further contributing to potential inflation is the prospect for an additional US$1.9 trillion in fiscal stimulus. The additional stimulus comes at a time where we may not have even seen the full economic impact of the prior fiscal programs and, as such, the excess liquidity may eventually result in an overheated economy — although that may be more a 2022 story and, at this point in time, may be viewed as a good problem to have.

Here’s a chart that shows the correlation between the percentage that small businesses have raised prices (according to the National Federation of Independent Business survey) and the percent change of the year-over-year personal consumption expenditures price index, from 1996 to January 2021.

If our views are correct, then we believe rising inflation and rising yields will be a key theme in 2021. While we don’t believe we have any edge in forecasting the short-term moves for bond yields, we believe that over our time horizon of six to 12 months, we’ll continue to see a gradual steepening of the yield curve that may continue to pose a challenge for long-duration investors over the coming year. For bond investors, we continue to believe a shorter-duration focus is warranted along with high-yield, investment-grade corporate debt and emerging market debt that should benefit from an improving economic environment.

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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Kevin Headland, CIM

Kevin Headland, CIM, 

Senior Investment Strategist

Manulife Investment Management

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Macan Nia, CFA

Macan Nia, CFA, 

Senior Investment Strategist

Manulife Investment Management

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