Base effects, gold, and the fastest jump in bond yields ever...
VERY CLEVER people keep saying inflation is coming, writes Adrian Ash at BullionVault.
Some have been saying it for years...
...pointing to zero interest rates and quantitative easing...
...and predicting that the value of money must sink to reflect the surge in its supply.
But on the official data at least, no. Most big central banks target 2.0% inflation. None have seen inflation reach and hold that level since before the global financial crisis.
So if there's one thing that the last decade or more has taught us, says our friend John Stepek at MoneyWeek magazine...
...recalling sage words from ex-SocGen strategist Dylan Grice, now of Calderwood Capital...
...it's that no one really knows what sparks inflation.
Well, not until Joe Biden won the White House.
Biden's stimulus risks "inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the Dollar and financial stability."
So says former Treasury Secretary Larry Summers, a Democrat no less who urged massive stimulus to try reversing the deflationary slump of the 2007-2012 banking and debt crises.
Here in 2021, handing out $1.9 trillion to consumers, businesses and infrastructure plans could "overheat the economy so badly as to be counterproductive," agrees Olivier Blanchard, former chief economist at the IMF and another 'establishment' voice if ever there was.
Put another way, "America is running an unpredictable three-pronged economic experiment," says the very centre-of-centre Economist magazine.
"It features historic levels of fiscal stimulus, a more tolerant attitude at the Fed towards temporary overshoots in inflation, and huge pent-up savings which no one knows if consumers will hoard or spend.
"This experiment has no parallel since the second world war. The danger for America and the world is that the economy overheats."
The bond market seems to agree, breaking a sweat as the apparent temperature rises. Hence the near fainting in gold.
Our chart above tracks in red the 5-year inflation outlook implied by 5-year US Treasury bonds. The jargon says that conventional yields minus TIPS yields equals the breakeven rate...
...and as you can see, the breakeven hasn't jumped this high since June 2008...
...summer of $150 crude oil...
...and eve of the global financial crash tipping into a crisis with the collapse of Lehman Brothers.
Now topping 2.5% per year, the 5-year inflation outlook priced by the bond market has of course spooked bond-market investors.
Because who wants to hold a bond yielding 0.4% per year...
...which is what Uncle Sam's 5-year debt offered as recently as late-January...
...never mind a lump of metal paying nothing...
...in a world of 2.5% inflation?
Hence the fall in bond prices...and not just in US Treasury debt...which has driven government borrowing costs up to multi-year highs, albeit way below the current rate of inflation, never mind the forecasts.
The 5-year US bond yield, for instance, offered to pay a peak last week of 0.8% per annum at one point.
US inflation for last month meantime came in at 1.7% on the official estimate.
Result? "Misery" to quote Dickens' Mr.Micawber, wondering how he will eat in retirement.
So what to make of these rising forecasts? Do they tell us anything useful? And might they force real interest rates to rise, finally rescuing your savings from negative real returns?
The dotted red line shows what the 5-year bond market was 'predicting' for US inflation 5 years earlier.
The blue line then shows you what US inflation actually turned out to be over those same 5-year periods...
...and the green line shows the 'core' inflation rate, much beloved of central bankers, stripping out volatile (if essential) things like food and fuel.
As you can see, the bond market has over-egged what will happen to inflation pretty much always. Yet it got very worried prices would fall in the 5 years to late 2013...and last spring it said inflation will fall near zero in early 2025.
Why forecast deflation? Prices did not in fact fall between 2008 and 2013. There's no reason to think inflation will slow near zero in early 2025 either.
But think about when those 'forecasts' were made.
Late 2008 marked the worst financial crisis in a century or more. Bank lending ceased. The global economy went into reverse. And the 5-year breakeven rate reflected that panic...
...rather than actually trying to 'predict' what would happen to inflation by late-2013.
February to April 2020 then saw the global economy hit a wall like never before, everything shut down and everyone got locked at home by the Covid pandemic and the authorities' response.
Again, the bond market reflected what it was living through, rather than what anyone actually thought might happen in 5 years' time.
Breakeven rates sank, only to rally...
...and now they're pushing higher to levels last seen before the global financial crisis.
There's a concept that explains this rebound: Base effects.
It means that what you see today...when you're looking at year-on-year comparisons like the rate of inflation or interest payments...depends as much on where you started as where you have got to.
And 12 months ago, as you no doubt recall, the price of useful stuff like copper, silver and platinum sank at the fastest pace in, well, in ever.
Oil prices in fact went below zero. You couldn't give the stuff away. Because there wasn't any room left in the storage tanks already stuffed with oil as Russia and Saudi Arabia pumped like crazy to try crushing prices to hurt each other.
Now we're back up at $70 per barrel of Brent, in part because of the economic re-opening, but also thanks to the Opec+ cartel (led by, erm, Russia and Saudi Arabia) agreeing to put and keep a lid on supply with the express aim of boosting prices.
So on an annual basis, the rally in crude oil...as well as copper, silver, platinum and all that other useful stuff...is dramatic.
So too is the rise in bond yields. Never mind that we've barely back up to what were all-time record lows when first reached over the last decade or so.
"Not a good take," said one bond trader when we posted this chart on Twitter last week.
And if you don't like this view, we have other ones. Lots, in fact, no doubt all equally bad.
But we do think that base effects from 2020's historic Covid Crash are playing a big part in driving inflation forecasts and expectations higher.
Indeed, we've been pointing to this effect since we found much smarter people signalling its risks as the inflation story began to take hold in late January.
Here in mid-March we also think that base effects are making the rise in bond yields look awfully dramatic too. And we guess this is what led hedge funds and algo traders to bet against gold in recent weeks.
You see, Monday last week saw the 10-year US Treasury yield settle above 1.59% per annum, its highest level in 13 months.
It's risen since to 1.74%. But more urgently, that Monday also marked the first anniversay of 10-year yield plunging to what remains a new all-time historic low of 0.54% amid the Covid Crash across financial markets.
That meant the rate of interest had tripled from exactly 1 year before, the fastest 52-week percentage jump on record. So it felt like a big jump, even though it left 10-year yields below the actual pace of inflation, eating real value for those investors (and retirement savers) who keep buying the stuff.
Bottom line? The risk of overheating is clear. As I say, it's making the bond market sweat, and it has made gold prices swoon. But that has been thanks more to base effects than to anything a long-term investor using gold to spread their risk might need to fear.
As for Joe Biden's historic stimulus, it's not only pundits and economists and magazine editors who think inflation could result. (Inflation helps sell business magazines, by the way.)
Chatting to a derivatives traders at a major multi-national last week, I suggested the inflation panic was getting ahead of itself.
His take? Chalk up another smart person fearing inflation.
Ten years ago, new QE and zero rates met a wall of 'austerity' from governments worried that the bond market would do to them what it did to Greece.
Today, in contrast, yet more QE and sub-zero rates are meeting very aggressive fiscal stimulus from the new US government.
Put another way, "For a decade after the global financial crisis of 2007-09," says The Economist, "America's economic policymakers were too timid. Today they are letting rip."
But really, "Is there a risk of inflation?" Biden's new Treasury Secretary, former Federal Reserve boss Janet Yellen, was asked at the weekend.
"I think there is a small risk and I think it is manageable," she said.
"And if it materializes, we'll certainly monitor for it, but we have tools to address it."
The main tools? My guess would be apathy, inactivity, and then blind panic when it's much, much too late.
Get ready in the meantime for the inflation story to roll over and retreat as the base effects from last March's Covid Crash wear off.
Crude oil went negative on 21 April. We could be in for quite the ride 52 weeks later.