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January 5- Inflation: The Key Variable in 2021

• “We believe inflation (and especially how the Fed respond to its resurgence) is perhaps the key issue for 2021.”

• “Once inflation has become ingrained, the monetary authorities will have to buckle. Remember the phrase “getting behind the curve”? At some point, the odds are that we will re-run the 2016 experience: when CPI spikes, yields inevitably follow.”

• “With likely ongoing fiscal deficits in the US, if the Fed allows real yields to rise, then we’d be looking at a policy mix of loose fiscal and tight monetary policy. Historically, this is extremely dollar bullish.”

• “What is surprising is that even though Covid has destroyed demand in whole swathes of the economy, cost-push inflation is showing up so powerfully. For example, just look at how in today’s ISM Manufacturing Index, the price component exploded. While it isn’t a perfect proxy for CPI, it does suggest sharply higher prices. In 2018, this level of the indexes helped deliver almost 3% CPI YoY.”

• “One area of concern is inflation, and we have been clear that we believe it is heading a LOT higher. Indeed, together with how the Fed responds, we view it as the key variable in 2021. Add to that mix the Biden Administration’s planned fiscal spending and you have a potentially toxic nominal GDP backdrop for fixed income.”

• “The point is that while markets are expecting higher inflation, we worry they are still dramatically underestimating the scale and immediacy of the threat.”

• “By the way, back in 2016, the rhyme we were using was 1987, when bond yields rose 300bps rapidly. But in both scenarios, markets leant too heavily on Fed officials’ platitudes, only to find out that they had misread the data. We can see the same happening again. This time, we expect officials will initially dismiss any price spike as “transitory”. “

• “we continue to expect price pressures to surge again this summer. To illustrate that point, look at this quote from the Chair of ISM. “Prices… 85.6, the highest number since July of ’08 and continuing to go up…”

• P.S. PPI hit 9.9% YoY in July of ’08. And the price pressures are not confined to just one sector. The ISM Chair noted increases in “plastics, steel, aluminum, it’s copper, brass, a lot of chemicals”.

• “If that isn’t enough, as services follow manufacturing’s recovery, we are starting to see those price pressures ripple through this dominant part of the economy. This was reflected in this week’s ISM Services Index, where all 18 industry groups reported increased prices. We believe this supports the view we expressed in our video, that PPI could hit 8% YoY, dragging CPI above 5%. That’s double the 2.5-2.6%, currently priced by 1yr US Breakevens.”

• “We have been unambiguous in expressing our concerns that the inflation numbers would be shocking, and when we look at our models, they still suggest the cost-push trend has momentum. The convenient shift to “final demand” PPI from the older “finished goods” PPI lopped 3% of reported PPI. But, statistical legerdemain aside, there is clearly still upside risk with the old measure of PPI, likely to exceed 10%.”

• “Bottom-line, the risks are on the topside, and a 6% handle is far from impossible”

• “If you take a 20% of GDP stimulus and try and jam it into an economy where the output gap could be considerably narrower. In fact, since his first warning, estimates based upon labour market slack now put the gap at 5-6%. At the same time, recent work by the CBO suggests that in Q1, the gap could have been as low as just 2% of GDP! Hence, our concern of the last few months that we could blow more than just the doors off the economy. P.S. We are in the process of modelling this dynamic, and the preliminary results are scary.”

•       “… the reality is that, despite Powell’s summary dismissal of the risks, his faith in the idea that “elevated readings are likely to prove temporary” looks misplaced. Indeed, when we examine the five specific arguments that underpin his sanguine stance, they wilt under interrogation from our trusty charts, ironically many of them based upon the Fed’s data. Hence, our concern is that the gentleman doth protest too much and that the Chairman is just winging it until there is greater economic clarity. “

  ·        “Bottom line, after Friday’s speech, it’s arguable that when it comes to inflation, Powell is at best clueless or at worst disingenuous and a pawn in the Biden Administration’s political agenda. At this stage, we think that is too harsh. Instead, we hope the speech was simply a reflection of genuine uncertainty in central bank circles”

  ·        “Unfortunately, if we have parsed the macro picture correctly, then in marked contrast to risk-assets price action since Friday, we believe the speech increases market uncertainty. As we have proved, the inflation arguments set out in JP’s speech are flimsy if not outright wrong. Obviously, just as May’s 53.4% rise in US Retail Sales was mathematically unsustainable, headline inflation will peak at some point. Yet for Powell to double down on the transitory argument, when policy remains at maximum accommodation, core price pressures are likely to remain uncomfortably high well into 2022, Owner Equivalent Rent is accelerating, and inflation expectations are already rising is dangerous.”

• “… with pent-up consumer demand, strong employment, robust wages and near record-low customer inventories, we just don’t see weak demand. That, in turn, suggests that firms with pricing power will continue to pass through prices, which means that inflation is the most likely outcome. For markets, that suggests that as we move into yearend and 2022, the transitory narrative will look increasingly laughable and central banks will look increasingly behind the curve.”