Inflation has resurfaced as a concern in recent months, with monthly core inflation rates surpassing 0.4% for the first time in over a year. This development has sparked fears of a potential inflationary comeback, reminiscent of the 1970s. However, a closer examination reveals contrasting signals and factors that suggest a different outcome. This article delves into the current inflation landscape, the historical context, and its implications for the US Treasury bond market.
The Historical Context of Inflation
In order to fully comprehend the potential implications of the current inflationary environment we find ourselves in, it is of utmost importance that we delve into the historical context of inflation. By doing so, we can draw upon past experiences and patterns to inform our understanding of present circumstances.
The decade of the 1970s, in particular, stands as a stark reminder of the volatility of inflation. It was a period marked by significant, abrupt jumps in the rate of monthly core inflation. These sudden increases served as warning signs, harbingers of an impending wave of inflation that was poised to sweep over the economy.
Drawing comparisons between our current situation and that tumultuous era has understandably raised some concerns. Fears of a potential repeat scenario, a return to the skyrocketing inflation rates of the 1970s, have begun to surface.
However, it is important to note that numerous spikes in core inflation occurred temporarily without leading to sustained inflationary periods. Inflation rates have remained relatively subdued since the 1980s, with central banks adopting more proactive measures to manage inflation expectations.
Current Signals from Financial Markets
Examining financial market data provides insights into market participants’ expectations regarding inflation. One key indicator is the 10-year Break Even inflation rate, which represents the difference between the yields of nominal Treasury bonds and Treasury inflation-protected securities (TIPS). This difference reflects the inflation expectations priced by financial markets. Currently, the 10-year Break Even inflation rate does not align with the recent increase in core PCE (Personal Consumption Expenditures) inflation. This divergence suggests that the market views the current inflation spike as temporary rather than a precursor to a sustained inflation wave.
Comparing Financial Conditions
A crucial factor in understanding inflationary pressures is the state of financial conditions. Contrasting the 1970s with the present, the Federal Reserve’s approach to managing inflation differs significantly. In the 1970s, the Fed loosened financial conditions rapidly, which stimulated the economy despite inflation being high. Today, financial conditions remain tight, indicating a different economic environment. The Federal Reserve has signaled its commitment to maintaining price stability and is prepared to take necessary measures to contain inflation if it becomes a persistent threat.
Debunking Deficit Spending as the Sole Driver
A frequently articulated worry when discussing potential inflationary pressures is the considerable upsurge in deficit spending and the amplification of the money supply. This concern is not without basis as we’ve seen how deficit spending and an accelerated money supply could indeed foster the inflationary pressures that were observed in the year 2021.
However, the current economic indicators and trends seem to paint a divergent picture. The growth in money supply, which was a key factor previously, has reverted back to a trend that is more in line with the pattern we’ve seen consistently over the previous decade and a half. This implies that there has been no remarkable surge in liquidity that can be directly attributed to deficit spending. Although future inflationary pressures may arise in response to economic downturns, the present conditions do not support such concerns.
Examining Inflationary Forces
A crucial indicator of impending inflation is the survey of prices paid by businesses. Historically, a rise in production costs has correlated with subsequent inflation. However, the current trend shows a decline in prices paid by businesses, similar to levels observed during the COVID-19 pandemic and in 2015, which resulted in low inflation. This divergence from the 1970s further supports the notion that the current inflation story is not repeating itself. Additionally, technological advancements and globalization have introduced deflationary forces that can counterbalance inflationary pressures.
Implications for the Treasury Bond Market
The US Treasury bond market experienced a significant decline in recent years, with prices dropping 51% from their peak in 2020 to their bottom in 2023. This severe bear market had a detrimental impact on traditional 60/40 portfolios (60% stocks and 40% bonds). While these portfolios recovered in 2023, concerns loom about another potential drawdown if a second inflation wave materializes. However, if the current inflationary pressures prove to be transitory, it could alleviate some of the concerns and provide support for the Treasury bond market.
The Treasury bond market plays a crucial role in the larger financial ecosystem. Treasury bonds are considered safe-haven assets and are often sought by investors during periods of uncertainty. They provide a fixed income stream and are backed by the full faith and credit of the US government. Inflation erodes the purchasing power of fixed-income investments, including Treasury bonds. As inflation expectations increase, bond yields tend to rise, leading to a decline in bond prices and vice-versa. This is the reason why bonds experienced a vicious bear market during the rate hikes in 2022 and 2023.
Opportunities for Traders
The correlation between inverted treasury bonds and the prices paid survey has been strong. While treasury bonds display concerns about a potential second wave of inflation, the data suggests the inflation story isn’t resurfacing. This mirrors the situation in 2021, where the bond market didn’t fully reflect inflationary pressures. The slow reaction of treasury bonds presents a high risk-reward trading opportunity
In our opinion, based on data, the inflation narrative is no longer a concern. This could present an opportunity in the bond market. The technical chart of the Treasury bond ETF (TLT) indicates a potential breakout, suggesting a recovery in bond prices. The next upside target lies at $109, while a sensible stop loss level would be $90. Traders should approach such opportunities with caution and implement risk management strategies.
Conclusion
While the recent increase in core inflation rates raises concerns, a comprehensive analysis of various factors suggests that the inflationary comeback narrative may not materialize. Financial market data, tight financial conditions, indications from inflationary forces, and historical context all point to a temporary inflation spike in core inflation rather than a sustained wave. This outlook offers a more positive perspective for the US Treasury bond market, with the potential for recovery from the significant bear market experienced in recent years.
However, it is important to monitor the situation closely as market conditions can change rapidly. Central banks and policymakers will continue to play a crucial role in managing inflationary pressures and maintaining price stability.
