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Inflation Matters

It has resurfaced. It was the same view that we articulated since last year. And now, it could set the stage for a broader price recovery especially in 2H of this year with stronger vaccine rollouts. As such, we should pay particular attention to the interaction between the general direction of inflation and the reaction of policy makers in driving the trajectory interest rates.

Inflation expectations in the US, proxying with the 10Y breakeven has climbed above 2% from a nadir of 0.55% registered last March and is about one standard deviation above its five-year mean. US CPI has averaged 1.7% over the past decade and has shown a general reading of above 2% in recent months. The same observation is made in countries like the UK, Germany, Canada, Australia and Japan which register a generally higher rate now compared to mid-2020.

One should distinguish between asset price inflation and consumer price inflation. With the unprecedented fiscal support and monetary easing, asset price inflation has surged at a tremendous rate. The S&P 500 and gold prices have risen by close to 20% since end-2019 – before the Covid-19 started. Bitcoin prices rose by over 300% over the same period even after accounting for the recent crash. Spot raw industrial metal prices and crude oil prices, which are more closely linked to economic activity have also risen but a lesser degree. The rise in commodity prices and the bottoming out of PPI numbers in China could point to an eventual increase in global as well.

In short, liquidity that is being pushed into the market is finding its natural way into traditional and alternative assets. What it means is that it is no longer cheap to use break-evens to hedge against inflation risks.

Subsequently, I am expecting authorities will allow the yield curve to steepen, especially driven by higher rates in long tenured bonds in coming months. Blue Wave in the US with a promise of another US$1.9 trillion by President Biden reduces the risk that fiscal policy gets pulled back before normalization in the economy can take place. Biden’s plan will include US$415 billion focused on fighting Covid-19, upwards of US$1 trillion on direct aid to individuals and families and another US$440 billion in aid to businesses, according to senior officials with the Biden administration. Once the global economy is on firmer footing, likely in the second half of the year, the case for inflation worries will come to the fore more prominently, along with the taper speculation, I expect another round of higher USD rates is likely, I am seeing an upside risk to rate to linger above 1.3% end 2021 for UST10 year yields and eventually to trigger similar policy reaction across G-10 countries. Fed’s refined new framework on forward guidance about federal fund rate and asset purchases in coming months will be a key important setting for any material regime shift for a more bolder, outcome-based guidance respectively.

Probably, the market is still dovish on the Fed and the move to bring forward hike expectations is just starting. As at now, I continue to advocate a core PAY position and to pay more on dips with anticipation of an economic recovery.

Chee Seng, Wong CIO, Athena Advisors