Another month, another US inflation report beating market expectations. Headline year-on-year consumer price index (CPI) inflation has gone from 1.1% last November to 4.9% in May. Even though economists knew that base effects meant the rate of price increases would accelerate, the figure still beat forecasts by 0.4% (after a 0.6% beat in April).
As investors perceived in April that supply chain bottlenecks and an arguably dysfunctional labour market were driving up prices and wages, near-term inflation expectations jumped (see Exhibit 1).
Even then, medium-term inflation expectations remained unchanged, reflecting the belief, and the message from the US Federal Reserve, that the price pressures were temporary and would subside once markets found a new equilibrium (albeit at a higher price level).
The Fed has also been clear that it would not adjust monetary policy in response to higher inflation over the summer. As a result, market expectations for the level of the fed funds rate in two years’ time held stable. Ten-year Treasury yields ended May 10bp below where they started.
After the recently released CPI report for May, however, one-year inflation expectations fell. One explanation is that despite higher-than-expected inflation, the increase from April to May was concentrated in energy. Within core CPI, the gains were principally within transportation (used cars, airfares and car insurance). Excluding energy and transportation, inflation rose from just 2.1% to 2.2% from April to May.
Stable medium-term inflation expectations and an indulgent Fed help explain why US Treasury yields have not risen over the last couple of months, but not necessary why they have fallen by nearly 30bp. One reason could be that US growth expectations have peaked.
After the release of disappointing non-farm payrolls, retail sales, and housing starts and sales, the outlook for the economy is not quite as bright as it appeared in March, soon after the passage of the latest trillion dollar fiscal stimulus package (see Exhibit 2).
Despite this disappointment, we expect the 10-year US Treasury yield to rise in the coming months. In our view, nominal GDP growth of over 6% through to the end of 2022 is not compatible with Treasury yields at current levels.
The relative contribution, though, from inflation expectations and real yields will be crucial in determining how equity markets react. Rising inflation expectations are likely to be less problematic, particularly as companies are in a strong position to pass along higher input and wage costs to consumers; demand should remain robust and supply/competition is constrained.
Higher real yields could be more problematic. These inflation-adjusted yields reflect both policy rates and growth expectations, so the correlation with equity markets can be either positive or negative depending on which factor is behind the change in real yields (the long-run average correlation is close to zero).
The positive impact of the fiscal stimulus has already been incorporated into earnings forecasts. An increase in real rates now would more likely reflect tighter monetary policy and thus feed through to equity prices via a higher discount rate, which would be negative.
We may soon be focusing our attention on sectors which are not only hedges against inflation, but which are also resilient against higher rates (see Exhibit 3).
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