Hyperinflation Risk Peaked. Inflation Risk Did Not

One common explanation for why Treasury yields have fallen the last few months is that inflation risks have peaked. In terms of the magnitude of possible inflation, that seems logical. I.e., peak inflation will prove to be the 5% CPI we’re expecting for the month of June, which likely marked the apex of the COVID-linked supply chain imbalance. Fair enough. But investors should be wary in assuming this means the disruptive potential of inflation on the market or economy has passed.

First let’s revisit the major turning points in the 10-year yield.

It bottomed in August last year with a gap-up rally from Aug. 10 to 11, the exact day the Federal Reserve released a study that signaled average inflation targeting (AIT) would be their new policy. Three months before vaccines were announced, the 10-year yield began its ascent.

The framework I proposed at the onset of AIT was that without the counteracting potential of rate hikes, the theoretical limit for inflation was infinite, and thus bond yields would climb until a point at which the Fed would have to change its tone. This meant we were likely to have a shock yield spike at some point when the economy began to pick up steam and imaginations ran wild. Just about everyone else argued that AIT would keep yields low. They were wrong. When yields surged in Q1, some said it proved the bond market “disbelieved” Powell. I argued it was the opposite; that it was the market truly buying into him, and processing what kind of hyper-inflation scenarios could exist in a world with lots of stimulus and no hikes. The result: we got one of the biggest yield spikes in history.

But that uptrend stalled out in the spring and ended rather abruptly on April 15, when the yield took a shock nose-dive after incredibly robust economic data. Retail sales surged 10% vs 6% expected, jobless claims were 130k fewer than the survey, and both Empire manufacturing and Philly Fed crushed estimates. All in one day. Yields plunged. Was it a giant “sell the news” event in which bond bears took profits as the economy hit some major milestones? Sure, that’s a decent explanation. But why did bonds reverse so hard on these data and not any of the numbers that were smashing expectations the preceding six months?

I believe it’s because the data by this point was so robust that the market began to realize the Fed would have to deviate course from AIT, which proved to be very bearish for the bond market over the preceding 6 months. The inflation surprise index took a big jump higher in April, and over the next few months, news headlines including “taper” started soaring. Yields declined.

Then we get to June FOMC, in which the Fed indeed shifts its tone, and yields plunge even harder. There’s little talk of AIT and lots of talk about economic growth, and the added twist of a few hikes getting pushed forward. The yield curve turns into a pancake, with the 30-5 curve erasing all its post-vaccine advance. Meanwhile, economically dependent sectors of the stock market are well off their highs. Crude oil, the most reliable inflationary commodity, remains well-bid even as commodities overall decline and the dollar is up.

Inflation is not getting priced out of the market, it’s getting priced in. Bond yields aren’t down because inflation risk is dead, they’re down because we already have enough inflation to complicate the path of our recovery. It likely won’t be the magnitude that seemed possible a few months ago when supply-chain disruptions and year-over-year comps skewed the data, but it’s been enough for the Fed to back away from AIT and for cyclical stocks to skid out.

Bottom line: people are too busy debating or debunking the merits of the hyperinflation story. The more important one is the potential for sticky, moderate levels of inflation that are enough to complicate the assumptions that have been built into markets right now. The hyperinflation argument looks weak (sorry bitcoin!), but so does the case for benign inflation when the Fed is already divided and cyclical stocks are under pressure. We may not be at risk of textbook stagflation, but there could be enough inflation relative to growth assumptions that the effect could be similar.

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