Nordea with the note. I see US inflation tumbling next year:
We see clear risks of a big positive surprise to the May inflation report as well with core inflation around or just above 4%. The market is still buying the transitory inflation narrative but for how long?
Lately, increasing (US) inflation has been the main concern of markets. A roaring economic comeback seems likely and this Friday’s coming job report is expected to confirm a declining unemployment rate and potentially a cheque-fueled increase in wage growth. Yet the inflation numbers have more to tell and we can elucidate which components are worth following closely over the coming months. We are likely in for another inflation shocker in June, but the question is whether the market will explain it away as a transitory effect.
- Clear risks of core inflation >4% in May or June already
- Headline inflation above 6%?
- Watch used cars and rent of shelter components in the May report
- Markets still find inflation mostly transitory
Clear UPSIDE risks to the May report (due 10th of June)
There are mainly two components to watch in the core inflation report due 10th of June. First, the price on used cars and second the rent of shelter component, while also transportation services were part of flipping the April core inflation report in an upwards direction.
Chart 1. Main drivers of core inflation in April (Contributions to YoY core inflation, %)
Prices on used vehicles increased by an astonishing 21 % YoY in April (contributing 0.8% to the yearly change in core inflation). According to Manheim Consulting, prices on used cars and trucks are expected to climb further to 50 pct YoY in May or June (3 months lag). If we assume a 50% yearly increase in used cars in May (Manheim may exaggerate the yearly price increase a bit), then core inflation will potentially surpass 4%. Supply chain disruptions, shortage of semiconductors and Covid-19 restrictions have all played a part in disturbing the price action in the car market, but bottlenecks are not always the root cause of inflation – they can also be seen as a symptom.
Chart 2. Prices on used vehicles increase as supply chain disruptions corrupt sales of new vehicles
The rent of shelter component played a big part in the slowing core inflation through 2020, which seems a bit odd given the smoking hot property market through the second half of the year and in to the beginning of this year. Will the reopening of the US economy lead the rent of shelter component back towards “fundamentals” such as inflation expectations, house price developments and the landlord asking rent? In such case the rent of shelter component may soon reach 2.5-3% territory YoY, which we find increasingly likely.
Chart 3. Rent of shelter to reconnect to reality over the early summer?
If we assume a 50% YoY increase in the used cars component, and hold everything but the rent of shelter component constant, we can showcase the outcome space for the core inflation print in May given various yearly price increases in shelter. If the rent of shelter component reaches 2.5% (we find that likely over the coming months) and the used car component prints at 50% YoY, then you already have a cocktail that could bring core inflation above 4%. This is CLEARLY above the early consensus at 3.4%. This is risk scenario for May, but seems feasible at the latest in the June report.
Chart 4. May core inflation given various levels of rent of shelter and assuming 50% yearly pick-up in used cars
There is still a noticeably clear scope for upside surprises to the level of price growth into the early summer, but it does not seem as if it is enough to truly rock the boat on the market positioning since everyone is aware of this early summer spike in inflation already. Our trend-model suggests that we can reach 7- 8% headline inflation this summer but whether it is enough to scare anyone, including the Fed, remains to be seen. The biggest monthly increase the US core inflation since 1982 (in April) hardly scared anyone but Robert Kaplan. Sustained positive surprises are hence of a bigger importance for markets than short-term directional positive surprises to the inflation outlook.
The true test is therefore whether inflation will stay around after summer. The “direct bonuses” of the Biden administration will run until September, but in parts of the US the cheques will already be halted during June (e.g. in Iowa and Mississippi), which will give us an early flavour of how the labour market looks post the money handout.
Chart 5. YoY headline inflation projection from our trend model
The market is still mostly stuck in a transitory inflation narrative. A 1yr zero-coupon inflation swap prints around 3.45%, which hints of an elevated inflationary summer before a retracement into the autumn again. Long-term zero coupon swaps price around 2.5%, which is fairly in line with the Fed AIT-regime targeting 2% PCE price increases on average, which should take CPI on average to 2.35% or thereabout. So the market has bought the AIT-regime shift and its credibility, but over the next year or two the market is likely still (severely) underestimating US inflation risks.
Chart 6. ZC inflation curve in USDs 1st of June
Another way to show that the market has accepted the transitory narrative is to look at 10yr bond yields versus core inflation. Should core inflation pick up to 4% (or above) in May or June, then the current 10yr bond yield will be almost 4%-points below the second lowest 10yr Treasury reading in a month with 4% core inflation or above. It goes to show that a latent pressure in long bond yields can still be unleashed, should the Fed just barely let go of its de facto curve controlling measures.
The Fed recently communicated that it will unwind the corporate bonds purchased in the Secondary Market Corporate Credit Facility that was created in the midst of the first Corona lock-down in 2020. The facility never came to large use (size 26bn USD) and the funding from the US Treasury for the facility was seized 31/12/2020, why the program size in itself is fairly insignificant, but it could be an early warning signal that the Fed is now starting to become more comfortable with the outlook.
Tapering is likely already in September as a growing minority within the Fed also hints. Buckle up accordingly in Fixed Income space.