Inflation expectations: hot air?

Mid-Week Bond Update

Inflation expectations: hot air?

The panic over higher rates and rising inflation that roiled financial markets over the past five trading days abated on Wednesday, as optimism on faster growth and improving corporate profits seemed to outweigh the concerns. Still, the world...

benchmark US Treasury 10-year bond yield traded at 2.78%, after reaching 2.84%, the highest since 2014. The turbulence’s trigger was US jobs and wage growth data, which came in above expectations, although some market observants insisted that inflation, still, is to be seen in a meaningful manner. Some even questioned whether the difference between the surging expectations and the real inflation rate is nothing but hot air (read more below).

Few Fixed Income asset classes survived the week, including short term US Treasuries, which have practically non-existent sensitivity to rising rates, and local EM bonds, denominated in local currencies. US non-agency mortgage bonds also posted small gains, driven by hopes of faster domestic growth. Corporate bond spreads widened, as investors demanded a higher risk premium given the expected higher financing costs. US financial conditions sharply tightened, given the higher rates and spreads. Long-maturity Treasuries suffered especially, given their higher sensitivity to inflation. The US dollar rose, hitting Emerging Market (EM) currencies, while oil took a tumble following increased output data.



Inflation expectations vs inflation: mind the gap: The difference between US inflation expectations and actual core inflation, which doesn’t include the more volatile energy and food prices, rose to 0.66%, the highest since 2014, following the strong January US jobs report. As seen on the chart, inflation expectations have been ahead of the actual inflation rate over the past 20 years, with the two variables only meeting on very few occasions. Some investors have already voiced their concerns about the rising expectations, arguing that long-term secular forces, such as technology, aging populations, high global debt and low productivity, are keeping a lid on price growth that may be difficult to remove. Departing Federal Reserve (Fed) chair Janet Yellen said in her last press conference that the challenges that are keeping US inflation below the Fed’s target may be ingrained and may also turn out to be permanent. Some investors seem to agree: the market-implied chances that the Fed will hike rates at its next meeting in March actually fell this week to 86%, after reaching 94% two weeks ago. Click here to read why Western Asset’s John Bellows believes that US economic and inflation growth may remain moderate.


Inflation: living up to expectations?

Inflation Expectations

Source: Bloomberg Barclays as of 7 Feb. 2018. Inflation expectations are measured by the Fed's Five-year Forward Breakeven Inflation Rate, while US core inflation is measured by the US Personal Consumption Expenditure Core Price Index. Please see disclaimers for definitions.


Mexico – economy spices up: The peso rose almost 1% against a surging US dollar over the past five trading days, the second-best performance among EM currencies, after the Chilean peso. The country reported an annualised economic growth rate of 1.8% in the fourth quarter, above expectations and mostly led by the Services sector. The Mexican currency has now gained 19% versus the greenback over the past 12 months, recovering the level it had before US president Trump won the Nov. 2016 election and threatened to build a trade barrier between the two countries. Supporting the currency, the central bank has kept a hawkish tone and embarked on a now two-year rate hiking cycle in order to contain inflation. Market-implied data shows an 80% possibility that there may be another hike this week.



Emerging Markets and US stocks – little relation: Leading EM bond indices fell over the past five trading days as rising Treasury yields and a sell-off in US stocks rattled financial markets. Yet, analysis of EM local bond returns shows that investors should look with almost equal interest to other variables, such as EM manufacturing data. As shown on the chart, the coefficient that calculates how responsive EM bond returns are to certain variables indicates that while the asset class is indeed highly responsive to US Treasuries (used as their risk-free base rate), they are also very sensitive to their own fundamentals, such as Purchasing Managers’ Index (PMI) data. Indeed, the improved global growth outlook is a tailwind for EM PMIs, which have increased to 53.6, the highest since data started being computed in 2015. Click here to read why Western Asset Chief Investment Officer Ken Leech believes that EM may continue to offer opportunity in 2018.


US stock sell-off: Should EMs bond returns shrug it off?


US Stock Sell-Off

Source: Bloomberg as of 6 Feb. 2018. The chart has been computed with a Multi-Regression Analysis, using the JP Morgan EMBI Plus index (translated in US dollars) as a benchmark for EM bond returns. The EM PMI index used is the Markit Emerging Markets Composite PMI index. PMI is Purchasing Managers’ Index. USD is US dollar. Please find definitions in the disclaimer.


Australia – waiting for a hike: The Australian dollar plunged 3% against the US dollar over the past five trading days, the worst performance among developed market currencies. The Australian central bank left interest rates unchanged at a record low of 1.5% for 18 months in a row as wage growth isn’t quite happening, despite improved business investment. Australia is one of many developed countries failing to stoke inflation, something which some investors attribute to low productivity and technology, among others (read more above). Europe, which is posting improved growth data, recently reported January annualised inflation of 1.3%, still well below the central bank’s 2% target.


Source for all data: Bloomberg and Barclays Capital as of 7 Feb. 2018, unless indicated.



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