Four ways to check whether inflation or deflation is coming next
The US Federal Reserve looks to be laying the ground work for its second interest rate increase of 2017, and the fourth overall of this policy-tightening cycle, judging by the market’s reaction to Wednesday’s policy meeting – and if that view is correct then advisers and clients will be hoping the central bank is accurate in its view that the weak first-quarter US GDP growth figure is just a blip.
Chair Janet Yellen and the Federal Open Markets Committee (FOMC) left the Fed funds target range unchanged at 0.75% to 1.00%, as had been widely expected.
Yet future markets priced in a greater chance of a 0.25% increase in US headline borrowing costs after the meeting, according to the CME Fedwatch tool:
Markets are growing in confidence that the Fed will hike rates again this summer
Source: CME Fedwatch, on 3 May and 4 May respectively
This is largely because bond markets latched on to a comment in the FOMC statement that:
“The Committee views the slowing in growth during the first quarter as likely to be transitory and continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will stabilize around 2 percent over the medium term.”
The first-quarter GDP growth number disappointed at just 0.7% on an annualised basis and that came on the back of poor retail sales numbers, a fourth straight year-on-year drop in auto sales and last month’s disappointing non-farm payrolls and wage growth figures.
None of that reads well so it is interesting to see the Fed maintain confidence in the economic outlook.
Yellen and her team are taking the view that the Q1 figure is an outlier and they may be encouraged to do so by recent history – as the Q1 figure was easily the lowest of the year in 2010, 2011, 2014 and 2016 as well.
The US economy has made an odd habit of starting a year slowly
Source: FRED, St. Louis Federal Reserve database
The strong rebounds in Q2 in 2010, 2011 and 2014 suggest that the seasonal adjustments to the figures are creating some distortions, although if the Fed does tighten in June and again in the second half – to meet its target of three hikes this year –and growth does not pick-up then there would be a risk that the Fed overdoes it and tightens policy too aggressively, choking off the world’s biggest economy.
That is a prospect which does not sit well next to global stock markets that are trading at or near all-time highs and global debt piles which are definitely at new peaks – it may not take much to dampen growth as the world is now much more sensitive to even small changes in borrowing costs.
For the moment, however, GDP growth in the UK, Europe and even Japan looks adequate at 2.1%, 1.7% and 1.6% year-on-year respectively in Q1, even if the US let the side down.
The prospect of a nasty shock from China also looks limited this year, not least because the authorities are unlikely to want such a thing ahead of the autumn’s Party Congress, when the great and the good will be looking to cement their political positions or jockey for advancement. The Communist Party will want to be able to reaffirm that all is well and the 6% to 7% GDP growth remains attainable.
As such, it is easy to say the US Q1 number was a blip, especially as President Trump’s reforms have yet to hit their stride – or even be introduced or passed into legislation for that matter.
The markets are therefore currently happy to go along with the dominant post-US election narrative, namely that global growth, inflation and corporate earnings increases will rise, and indeed accelerate, as the Trump reform plan slots into place and wage growth starts to perk up.
The alternative, of a disinflationary slowdown, or even deflationary downturn, is not on markets’ radar for the moment, but advisers and clients will know the value of stress-testing the consensus view. As the British philosopher and logician Bertrand Russell once asserted: “Even if all the experts agree, they may still be mistaken.”
It may therefore be worth advisers and clients keeping their eyes on four simple tests which will test whether inflationary trends are taking pole position, or whether the real dangers of disinflation or deflation still lurk.
The first is forward inflation expectations. As can be seen here, President Trump’s win prompted a spike in the US five-year, five-year forward inflation expectation.
That initial burst has begun to fade a little although expectations are still higher than they were a year ago, or on 8 November 2016 when Trump prevailed. As such, the signal here is mixed but offers just enough comfort to buyers of the reflation trade.
US inflation expectations are retreating a little
Source: FRED, St. Louis Federal Reserve Database
Government bond yields are inextricably linked to inflation expectations, so it makes sense that they should also be a good indicator as to whether inflation or deflation is on the way.
In the USA, 10-year Treasury yields are still above where they were a year ago or on 8 November 2016, although they have retreated this year, to suggest some ebbing of faith in the Trump trade. Moreover, UK 10-year Gilt yields are well below where they were twelve or six months ago, although that may be as much to do with Brexit concerns as it is fears of deflation.
As such, this is another indicator that looks mixed though it offers just enough for the inflation camp for now.
Government bonds are refusing to sell off decisively
Source: Thomson Reuters Datastream
Less encouraging is the gathering sell-off in commodity prices. Oil, copper and others are all some way off their recent highs, to suggest all may not be entirely well with the world economy. Resources stocks such as miners have begun to flag badly too. This is a trend to watch as for the moment it is warning that the reflation trade could be going astray.
Commodities prices and mining stocks are starting to suffer
Source: Thomson Reuters Datastream
One economy that is particularly sensitive to commodities and Chinese demand for them in particular is Australia. The Aussie dollar is used by many a fund and hedge fund manager as a guide to global economic health and the bad news is the currency is trading at a four-month low against the US dollar. This also suggests the reflation trade may not be the certain winner many think it to be.
Aussie dollar is losing altitude
Source: Thomson Reuters Datastream
That makes for a 2-2 draw, perhaps making the case for a balanced portfolio that caters to a range of possible market outcomes, not just the current prevailing narrative.
Advisers and clients are certainly unlikely to want to be swayed too much from their agreed strategy, given that the election of one politician or another is unlikely to make too much difference to their target returns, time horizon and appetite for risk – and the longer the time horizon, the less likely they will want to account for short-term developments, no matter how noisy.
As the American economist Robert Solow once stated: “Economists are often asked to predict what the economy is going to do. But economic predictions require predicting what politicians are going to do – and nothing is more unpredictable.”