The latest PCE print was weak. As a result, some analysts have suggested that low inflation will likely persist.
However, several leading indicators point to an upside surprise in the U.S. inflation.
The bond market is not prepared for accelerating inflation as traders are still pricing in a sub-2% inflation rate and a lower-for-longer interest rate environment.
As such, higher-than-expected inflation figures could lead to a dramatic shift in the markets.
The reflation theme remains one of the most hotly debated topics among investors. Some analysts have recently suggested that low inflation will likely persist, given that the latest PCE (Personal Consumption Expenditures) print was weak. As the table below shows, US Personal Consumption Expenditure Index increased by 1.3% y/y in August, while consensus had expected it to grow by 1.4% y/y.
Indeed, the PCE indicators have been soft over the past several months. However, if we take a look at several leading indicators of inflation, the numbers will tell us a completely different story.
ISM Prices Paid delivered a huge beat
Last week, the Institute for Supply Management (ISM) published its Manufacturing and Non-Manufacturing PMI surveys. As a reminder, PMI surveys track sentiment among purchasing managers. Notably, the ISM Priced Paid Indices, which are traditionally viewed as a good indicator of business sentiment regarding future inflation, delivered a huge beat. Both ISM Priced Paid Indices came in well above market expectations and reached their 5-year maximum levels.
One can argue that the ISM Indices were significantly above expectations due to the hurricanes. However, it is worth noting that both indicators have been on a rising trend since June. Importantly, as the chart below shows, over the past 20 years, there has been a very strong positive correlation between the ISM Non-Manufacturing Prices Paid Index and the Consumer Price Inflation (CPI) Index. Notably, the ISM Prices Paid Index has been a reliable leading indicator of the CPI data so far.
Higher oil prices
It should come as no surprise that oil prices are a large part of consumer price inflation in the United States. The chart below illustrates that there has been a strong correlation between WTI oil prices and the US CPI Index.
Crude oil has rallied by almost 20% since mid-June, and such a rebound should certainly result in upward pressure on inflation. It is also worth noting that oil prices have a substantial impact on inflation expectations, as measured by the so-called Breakeven Rates, which is calculated by subtracting the yield of TIPS (Treasury Inflation Protected Securities) from the yield of the nominal Treasury note.
Wage inflation is real
New York Fed President William Dudley said that a tightening labor market and gradual wage growth should trigger a pick-up in inflation. The September employment report confirms his thesis. The chart below shows that average hourly earnings rose to an annual pace of 2.9% in September, which is the highest level since the global financial crisis.
There were a number of reports from bulge-bracket investment banks saying that the Philips curve is dead. For starters, the so-called Philips curve is an economic concept showing that inflation and unemployment have a stable and inverse relationship. Janet Yellen said that the Phillips curve is a core component of every realistic macroeconomic model. Importantly, the Fed Chair maintains a strong belief in the concept.
The Phillips curve is a core component of every realistic macroeconomic model. It plays a critical role in policy determination because its characteristics importantly influence the short- and long-run tradeoffs that central banks face as they strive to achieve price stability and, in the Federal Reserve’s case, maximum sustainable employment—our second, congressionally mandated goal.
We believe the September employment report confirms that the Philips curve is alive. Some critics argue that the Philips curve does not work anymore as the unemployment rate has fallen since 2010, but the inflation rate still remains low. However, if we look at the chart below that illustrates how the Phillips curve has been working for the past 60 years, we see that historical trends show a similar pattern of economic cycles with gradually falling unemployment and low inflation. Most importantly, as the chart shows, these cycles generally ended with a spike in inflation.
The bond market still expects low inflation
Surprisingly, the bond market (TBT) (TLT) (TMV) is not prepared for accelerating inflation as traders are still pricing in a sub-2% inflation rate and a lower-for-longer interest rate environment. The narrowing spread between the yields on 10-year Treasuries and 2-year Treasuries suggests that the bond market is showing a sign of caution over economic growth and inflation trends in the U.S.
As such, a potential inflationary spike could cause a major shift in the bond market.
The best places to hide
While stocks are generally seen as a good hedge against inflation risks, history tells us that U.S. Financials are the biggest beneficiary of the inflationary pressure. The charts below illustrate the thesis.
We believe a combination of higher oil prices, wage growth, fiscal stimulus and proposed tax cuts could trigger a spike in inflation. Most importantly, the bond market is not prepared for accelerating inflation as traders are still pricing in a sub-2% inflation rate and a lower-for-longer interest rate environment. As a result, a potential inflationary spike could cause a major shift in the markets.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.