Inflation jitters: what we’re watching

Will the inflation genie return to its bottle once pandemic price pressures pass? For the moment, financial markets seem to agree with the Fed’s view: that inflation pressures are transitory or already priced in. Perhaps more interesting is the potential long-term impact of the Fed’s new inflation policy on bond markets. Tolerating longer periods of higher inflation to achieve a 2% average over time could make asset prices more sensitive to changes in yields. Some argue this could present a duration challenge for investors, and ultimately change the dynamic of bonds being viewed as a hedge for equities. In the nearer term, we’ve already seen ‘lower rates for longer’ feed voracious corporate appetite for debt. If that becomes the new norm, higher debt levels against a lower rate backdrop could force a recalibration of investor risk tolerance.

Evidence that investors are still on board with the central bank’s hypothesis has abounded in recent weeks, with several inflationary indicators normalizing.?Among the more eye-catching moves, lumber futures fell more than 40% from peak levels in May, providing relief to real estate supply/demand technicals that had been turned upside and resulted in a $36,000 increase in the cost to build a new home on average this year, according to the NAHB. Another sign of optimism: our indices show that investors are demanding less yield to hold US corporate debt, with the premium between corporate debt and Treasuries at its lowest level in over a decade.

More traditional inflation metrics like gold have also come under pressure, with bullion prices down nearly 7% month-over-month.?The fixed income crowd would likewise point to their preferred canaries in the coal mine, TIPS break-even rates and Treasury yield curve steepness, both of which have declined from 2021 peaks.

Amid inflation jitters, one gauge we’re keeping a close eye on is the MOVE - the often-overlooked index which captures fear in the bond market. Inflation was already at its highest level since 2008 when the Fed brought forward its rate rise projections this month, triggering a brief slide in equities and a jump in Treasuries. Now, all eyes will be to Jackson Hole. The Fed has indicated it’s just a step away from “talking about tapering” and that symposium has historically been a forum for policy announcements.

Until next month, enjoy the summer. And Happy Fourth if you are based in the US.

Lynn