US Inflation — seemingly calmed but what’s ahead for the reflation trade?
Posted 12 July 21
Interview with ausbiz, 12 July 2021
During an interview with an independent finance and business news broadcast, ausbiz TV, our CIO Paul Ashworth shared his analysis and views on current US inflation. We have seen expectations for US inflation moderate, and US bond rates test lows of 1.25% having been over 1.60% over a month ago. The reflation trade is accordingly coming under some pressure. However, Paul thinks this view is premature and that reflation and the reflation trade is an occurrence likely to persist for some time to come.
So, let’s review what has happened?
We previously noted our views that the current inflation through goods inflation was a shorter time event, driven by a run down in inventories and some pricing power to various resellers. For example, the new and used car sector. The used car prices are up 30% over the last 12 months, and the car rental market rose 110% over the last 12 months. This is largely transitory and will correct. While in the short run, bond and equity markets have correctly interpreted this, as reflected by bond rates declining and equity markets unconvinced about the reflation trade. Cameron Harrison believe these risks are too short term and risks missing future pressure on core inflation.
The Fed seeks the dual aim of full unemployment and inflation around 2%. The risk is of inflation overshoot, which the Fed states it can tolerate, but can it really manage it? We have some serious doubts.
What is ahead of us?
The next phase of inflation will focus on services and housing costs, which are central to core inflation (goods inflation is not as compositionally relevant). With the pursuit of full employment and consequent wages growth potentially beyond that required to sustain 2% inflation, the Fed’s hand will be pressured to act to increase rates. What this means is that the more significant core inflation measure, driven by services and shelter (rents) and fueled by higher wages growth, is ahead of us. This is what the inflation markets should be more focused to, as we are.
For the reflation trade, we consider this paused, and in fact, the key impetus and action is ahead of us, not behind us. All things being equal (and COVID, vaccination and strains a key proviso). At Cameron Harrison, we think the Fed is likely to be pressured on the cash rate at the end of 2022 or early 2023, and markets will assess this core inflation risk by again marking up 10-year bond rates. If the Fed permits a significant core inflation overshoot, we suspect based on history, they will manage this poorly and cause a recession.
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