Is Dis-Inflation a Worry?

Is Dis-Inflation a Worry?

Since the surprisingly weak CPI report earlier in September, there’s been a subtle but growing concern about the return of dis-inflation—not in the EU, but in the U.S.  And, recently we’ve seen a fair bit of financial media coverage detailing the fall in market inflation expectations—so I wanted to cover the topic and explain why we’re seeing that dip (it’s not entirely because the market is expecting dis-inflation).

Renewed worries about dis-inflation have come from three places:

First, commodity prices have utterly collapsed since earlier this summer, which obviously weighs on inflation statistics.

Second, despite the stock market reacting “dovishly” to the last Fed meeting, bonds and the dollar are beginning to price in the reality of a rising Fed Funds rate in mid-2015.  Given the apparent lack of statistical inflation, the reality of a higher Fed Funds rate will dampen expectations for inflation 5 years out.

Third, and most-cited, both the 5- and 10-year Breakeven Inflation Rate have dropped precipitously over the past three months. (The breakeven inflation rate is the difference between the yield on a Treasury bill vs. the yield on the same-duration TIP.  So, the 5 year-inflation break-even is the yield on the 5-year Treasury minus the yield on the 5-year TIP.)

These events have led some to become worried that the U.S. is about to go through another period of “dis-inflation.” If that does indeed happen, then stock  prices will get hit—potentially hard (because the Fed is basically out of monetary bullets).  It’s also led some to believe the Fed may end up being slightly more “dovish” than is currently expected.

But, yesterday we got some encouraging news on inflation.  The August “Core PCE Price Index,”  which is the Fed’s preferred measure of inflation, was unchanged from July, at a +1.5% increase year-over-year.  Importantly, it didn’t confirm the drop we saw in CPI in August, and should help to alleviate some concerns about dis-inflation (this was underappreciated by the market yesterday).

Turning then to the “inflation breakeven,” with regard to the drop in the 5-year inflation breakeven, that number is very highly correlated to commodity prices. If you’ll look at a chart of the 5-year breakeven yield (link here), it started to decline very shortly after commodity prices began to collapse in late June.  So, it would appear most of that has to do with commodity price declines (so it’s mostly a commodity phenomenon, not something more structural and worrisome).

The 10-year breakeven is a bit more worrisome, but if you look at that chart, what you’ll see is it really came for sale hard following the lackluster jobs report of August. What I think the 10-year is reflecting is the lack of wage inflation, as represented by the poor August jobs report.  Remember, wage inflation begets real inflation, so until we start to see material wage inflation (which will come from further labor market improvement), expect the 10-year inflation expectations to remain relatively subdued.

Bottom line, dis-inflation is a background risk we need to monitor here in the U.S.—but at this point the low inflation readings seem to be more a product of commodity price declines and sluggish wage inflation … not an indicator that the market’s fundamental outlook on inflation going forward has materially changed.

This was an excerpt from a recent edition of the Sevens Report, the only daily publication that provides you with everything you need to know about the markets, by 7:00 AM each morning, in 7 minutes or less. To try the Sevens Report free for two weeks, simply sign up on the right hand side of this page.

What the ECB Balance Sheet Means for Stocks and Bonds

The Key to Europe—the ECB Balance Sheet (What It Means for Stocks and Bonds)

ECB 9.30.14

What Happened:  Part of the reason we’ve seen a rally over the past two days in the Treasury market is because of Europe—specifically the “dud” of the first TLTROs late last week.

Not only was demand for the initial offering poor (86.4 billion vs. (E) 150 billion euros), but on Friday European banks actually repaid nearly 19 billion euros worth of the previous LTRO, making the total addition to the ECB balance sheet only about 67 billion (86.4B – 19B)—less than half of the 150 billion the market expected.

Why It’s Important:  The size of the ECB balance sheet is very critical to the economic recovery in Europe.  QE, TLTROs, ABS purchases and all the other acronyms are simply tools being deployed to accomplish the same goal—to get the ECB balance sheet to rise.

The logic goes that if the ECB can expand its balance sheet and pump money into the system, then they should create economic growth. That would in turn create inflation, which would then solve the deflation problem they are currently experiencing.  (That script has “worked” in the US, UK and lately, Japan).

So, to keep things simple, an expanding balance sheet is inflationary and positive for growth, while a contracting balance sheet is deflationary. And as you can see from the chart, the ECB is the only major central bank whose balance sheet has been contracting.

How We Make Money Off It: If the ECB fails to materially expand its balance sheet, then deflation will get a tighter grip on the economy. European bonds will rally like they did for most of this year, and that will put upward pressure on Treasuries—just like it did from March to September.

As the ECB implements these measures (TLTRO, ABS), you will see the market waver in the short term between thinking the measures are working (and the balance sheet expanding, which is Treasury-bearish) and the measures failing (as in the case of last week, which is Treasury-bullish).

Treasuries will be much more sensitive to the short-term data from Europe than stocks.  But importantly, as long as the ECB remains committed to expanding the balance sheet, any short-term rally is “noise” compared to the overall negative trend in bonds.

European stocks should be much less sensitive to short-term fluctuations than bonds.  That’s because, as was the case last week, the failure of the initial TLTRO was just seen as further increasing the odds of QE. The ECB simply cannot fail to increase its balance sheet and spur a recovery—because if they do, it’s very likely the EU would split apart. (Southern European countries are not going to stay in the EU if deflation takes hold—they will break away and devalue their own currencies.)

So, bottom line is this:

“Short bond positions” will see volatility depending on what’s happening with the ECB balance sheet, because it will directly affect Treasuries.  But, the trend should remain lower in bonds as long as the ECB remains committed to balance sheet expansion. So, don’t get spooked by counter-trend rallies.

For “long Europe” equity positions, the trend upward should be more smooth, as stocks are clearly viewing “bad as good” in Europe—as long as the expectation remains that the ECB will eventually do QE.  Point being, the trends (Treasuries down, European stocks up) remains in place despite the fact we’re likely to see some short term counter trend moves.

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Sevens Report 9.30.14

Sevens Report 9.30.14LDE