The reflation and inflation meme tightened their grip on the markets. Interest rates have risen, and curves have steepened. Two events occurred around the same time in early November that sent a similar signal: the US election with prospects for significantly more stimulus and a vaccine's availability. Since the US election and the announcement of a vaccine in early November, the 10-year US break-even has risen from about 165 bp to over 225 bp, before finished the week near 2.15%. accounting for the nearly 50 bp increase in the nominal 10-year yield.
The CRB commodity index has gained nearly 30% between the vaccine news and the enhanced prospected for additional significant US stimulus. It has risen above the pre-pandemic 2020 high and is at its best level since late 2018. Oil prices are an integral part of the story. After finishing October below $36 a barrel, with the help of a devasting storm in the US midwest, April WTI pushed above $62 a barrel last week before pulling back ahead of the weekend. Copper prices are at their highest level since 2011, up a third since the end of last October. Iron ore prices have risen by more than a third as well. The price of lumber has almost doubled. It is not just industrial products; the price of foodstuffs (soy, corn, wheat, and some livestock) and fiber (cotton) have also appreciated.
Isn't this rise in commodity prices a slam dunk case of inflation? There are mitigating considerations. Residents in high-income countries buy more services than goods, and the goods they do buy, are not as commodity-intensive as they were previously. The cost of a cell phone or laptop computer is not linked to commodity prices. Even some appliances, like a refrigerator, stove, and laundry machine, do not seem particularly sensitive to metal prices. It is estimated that the price of many consumer goods could be 50% or more above the import cost like transportation, storage, and insurance middlemen must be fed.
Another mitigating factor is that backwardation that is evident in many, though not all commodities. It is when the near-term prices are higher than future prices. Backwardation is to commodities what an inverted curve is to the fixed income market. April WTI is above $60 a barrel, while the December contract is near $55.50. March lumber is hovering a little below $1000, but lumber for September delivery costs about $725. Copper and iron ore are in backwardation, as well, though more modestly. Soy, wheat, corn, and sugar are dearer now than in the future.
The economic slack may also limit some types of price pressures. Consider that more people are filing initial unemployment claims that during the peak of the 2008-2009 financial crisis. Around 10 mln people who had jobs a year ago don't now. Industrial capacity usage to 75.6% in January, the highest since last February. It was over 79% in 2019 before finishing the year near 77.2%. And even then, the Fed's inflation target was elusive.
Recall what CPI measures. Housing and healthcare account for a little more than half of the basket. From another perspective, food, shelter, and clothing account for nearly 60% of the CPI basket. The Bureau of Labor Statistics calculates the CPI and does not have track energy as its own item, but rather it is embedded in other categories, such as transportation and housing. It estimates that overall energy accounts for about 6.2% of overall consumer expenditure.
That said, no one, including Fed officials, is simply dismissing signs of some price pressures. Of course, they are evident. The issue is two-fold: whether it is a general or relative increase in price prices and whether is the increase temporary or permanent. Recently, some food companies have suggested that they are considering passing on higher grain and sugar and edible oil prices to the consumer. The January CPI figures showed at US consumers paid an average of 3.7% more for food at home than they did a year ago. The basket of goods households are buying during the pandemic has shifted, which impacts relative prices.
A small rise in yields translates into a significant decline in bond prices at that these levels, and inflation dynamics are front and center to many investors, especially in fixed income. However, Federal Reserve Chairman is unlikely to dwell on inflation when he testifies before the Senate Banking Committee on Tuesday and the House Financial Services Committee on Wednesday. The pre-release written remarks reiterate what he and his colleagues have recently said. Monetary policy will remain extraordinarily accommodative for some time. Without addressing specifics, Powell will likely repeat his praise of the past fiscal stimulus and renew his call for more around the same time that the House of Representatives passes the $1.9 trillion stimulus package.
Trimming purchases are not being discussed. Unemployment is the immediate concern. Weekly initial jobless claims continue to run above the Great Financial Crisis's peak, and around 10 mln fewer people are employed compared with a year ago. Last year, the Fed adopted a new policy framework, seeking an average inflation rate of 2%, which signals a willingness to let the economy run quicker than it did in past cycles. Far from being problematic, the rise inflation expectations are precisely what the Federal Reserve sought.
Indeed, as we noted, the rise in inflation expectations, judging from the behavior of the breakevens, explains in full the rise in nominal yields. Interest rates have two components: the real rate and the premium. The latter in the US is operationally reduced to inflation expectations. Consumer prices rose by 1.4% in the year through January. The implication is real rates have been fairly stable. Expectations are for a greater increase this year. The 10-year note yield is near 1.35%, up from around 0.85% in late October. The 10-year breakeven (the yield difference between the conventional note and the 10-year TIPS) reached 2.26% last week, the highest in seven years, and finished the week around 2.16%. It was near 1.65% on the eve of the election.
The January personal income and consumption data are among the more meaningful US reports next week. Income will be bolstered by the government's $600 payment authorized in the $900 bln stimulus bill passed at the end of last year. Personal spending will not keep pace but is likely to have risen for the first time since October. Although retail sales account for a little less than half of the GDP's consumption component, the outsized jump in January (5.3%, the first increase in four months, and beating Bloomberg survey's median guesstimate of 1.1%) warns of the direction of headline risk for the personal consumption expenditure report.
The Fed targets the PCE deflator, and the surge that is purely a function of the comparison with the last year's decline will not be evident until the March and April readings. In January and February 2020, the PCE deflator rose by 0.2% and by 0.1%, respectively. The shock came in March when prices fell by 0.3% and tumbled another 0.5% in April. The year-over-year pace may stay around the 1.2% average from H2 20 before surging above 2% in the spring. The Fed talks about the core PCE but does target it. It averaged about 1.4% in H2 21. The decline last March and April was less severe (-0.1% and -0.4%, respectively. Therefore the base effect will also be less dramatic.
With a little bit of luck, Chair Powell will be asked about his working relationship with Treasury Secretary Yellen. She is about to make Powell's life more difficult. The Treasury will reduce its cash hoard by about $1.1 trillion in the next several months. Admittedly, it is partly required to under the debt ceiling suspension rules. As the Treasury reduces its cash balances at the Fed and reduces its T-bill supply, more downside pressure will be exerted on short-term money market rates. It will jeopardize the effectiveness of the Fed's lower bound (reverse repo rate, RRP, is zero). Last week's four and eight-week T-bills were sold at a zero yield for the first time since March 2020.
Negative T-bill rates are possible again. This is not the first time where the Treasury's cash management became a source of disruption in the money markets. There is speculation that the Fed may, as it has done before, make a technical adjustment to either the interest paid on reserves (not just excess reserves) of 10 bp and the RRP. Given the market's sensitivity to the tapering discussion and scar tissues still from the tantrum in 2013, it may be awkward for the Fed to have to explain raising rates even if for technical reasons.
Powell & Co is approaching another critical decision. Last year, the Fed temporarily exempted bank holdings of Treasuries and reserves held at the central bank from the leverage ratio. The forbearance is set to expire at the end of next month. Officials have made it clear that it is an exception and not permanent. However, banks' need to absorb the Fed's money ($80 bln a month of Treasury purchases and $40 bln of Agency MBS) and function as financial intermediaries during these unusual times makes an extension likely. It may turn out that the regulatory relief is as temporary as the Fed expanding its balance sheet. If on the slim chance that an extension is not granted, the funding markets, in the first instance, would become less liquid and more volatile, while bank shares could come under selling pressure.
Disclaimer
Reviewed by Marc Chandler
on
February 20, 2021
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