Ear to the Ground

July 1 2022

It has been a quieter week for economic releases this week but that does not mean this has been reflected in investment markets. The inflation debate continues to rumble on, with investors and market analysts trying to anticipate when and where it will peak. Inflation appears to be on a different expansionary path in some countries and regions when compared to others. There are many drivers behind inflation and it is this composition which will undoubtedly be a key determinant.

In the Euro area, energy costs are proving a key driver. This is also a key driver in the UK, although not to the same extent, with the cost of core goods being a larger contributor here. In the US the contribution from energy is smaller still, but here inflationary pressures are coming from a broader range, with inflation from services much stronger here than in the UK and Euro area.

Whilst inflation remains a key risk, there are some signs that the market is anticipating that inflation will start to fall from its current high levels. Treasury Inflation Protected Securities (TIPS) are currently implying that inflation will have fallen to 4.5% in the US over the next twelve months. The TIPS implied inflation over the next five years, starting in five years, also known as five years five years, forward, suggests inflation will head back towards the 2% level.

The market is also pricing in positive real interest rates in the US, despite there being elevated inflation expectations. Given the signals we have seen from the US Federal Reserve, are they now behind the curve?

There are of course many factors which could still have a significant impact on the inflation outlook, including higher wages costs or a further spike in commodity or energy costs. Still, the rhetoric does appear to be increasing towards a slowdown in economic growth and indeed a recession. The US saw a contraction in the first quarter and the Atlanta Fed GDPNow model is forecasting negative growth for the second quarter. As a reminder, a technical recession is two consecutive quarters of economic contraction. The question, therefore, and one up for debate, is whether we are to see a hard or soft landing. Much will depend on how far central banks feel they need to tighten monetary policy, both through higher interest rates and quantitative tightening, and how much governments can step into the breach with fiscal policy support.

The slight change in rhetoric has of course had an impact on asset markets this week. Concerns of a slowdown potentially has negative connotations for operating margins and profits for corporates, causing some weakness in equity markets. The shifting of some focus from inflation to growth meanwhile has been more positive for government bonds, in particular longer duration, where we now see the US 10 year Treasury trade below 3%, off its recent highs.

The US yield curve is now very flat with, at the time of writing, the 2 year yielding 2.85%, the 5 year 2.93% and 10 year 2.94%. Probably too early to call the peak in yields just yet in the US, but relief for fixed income investors, in the short term at least.