Macro: Revisting The Dog That Did Not Bark

Very recently we have seen some rising voices on the upside inflation possibilities from various corners.  Soberlook covered it the other day. Deutsche has recently had a rather strong publication. Even the St Louis Fed has something to say on this. I am not so sure that inflation is just around the corner, but I have also covered it before (See here,here, here and here). The point is not to say we should worry about rising inflation now. The forecasting accuracy of economists are, well, not certain. And hence as market participants, investors should care about other possibilities than just their beliefs. Even when (and perhaps especially when) they tend to diverge. And these points are valid concerns to juxtapose against a general deflation concern, driven by Chinese and European economies.

The major points raised in favor of a more positive outlook on inflation are broadly 

• the recent rising inflation in the US
• the subdued wage inflation may be just a lagging indicator, and when corrected for productivity gain, unit labor cost inflation may be higher 
• inflation markets are too pessimistic about oil and finally 
• fighting deflation may be unproven, but fighting inflation is not easy either. 

Let's look at some charts to see where we stand on this. To start with, what is driving the recent pick up in inflation  in the US (click to enlarge)

Yes, it has been mostly driven by a recovery in the transport (read energy) component, and steady housing and healthcare components. The massive fall in oil price in late 2014 skewed the transport component and if oil steadies at these levels, this major effect will cancel out (as the Fed expects).

However, that is no cause of merriment, looking at a broader picture. As alleged, the wage rise has indeed been subdued, to historical standard. And as pointed out by numerous analysts, the traditional Philips curve has been much weaker (the chart on the right shows correlation to wage growth and inflation, with shaded area as US recession). Oil, and in general commodities have, in recent times, much stronger correlation to inflation that wage growth. Now this can be read as you like. One hand this means even an increase in wage may not reflect in a substantial increase in inflation (argued from the supply side, with so much excess capacity in the commodity sectors, which most analysts generally agree upon). On the other hand, notice the case of the early 90s recession and how the wage and inflation correlation picked up during the late stage of the recovery. As I have mentioned before, the current recovery is not entirely unlike that of this one.

The take-away here is wage growth or not, the supply side excesses will have to run its course before it can put pressure on commodity prices (perhaps not much downside from here, at the same time). What we really should try to figure out is what is the health of the demand side.

And here we see the mixed signals, especially if we consider the global point of view. Below charts shows GDP-weighted headline and core (ex-energy) inflation. While we have a strong recovery in the US, the rest of the world does not look that impressive at all. It is true we are not very much near a deflation scenario given the current levels, but not a fat lot of improvement in sight.

The point here is more nuanced than worrying about either deflation or inflation. On one hand we should remind ourselves not to write of return of inflation. On the other, we may not be near deflation, but that situation may change drastically if we face a sudden crisis. Given the current monetary and fiscal policy stance, it is very hard to see the wriggle room. And that is precisely the reason to worry for risk assets. Given status quo we should do fine. But in either case it is hard to see a fitting policy response that is credible and effective in either way. It is more like a short convexity trade. If you are in it, you better make sure you are getting paid for it.

Finally, yes, the oil market is indeed pricing the scenarios too pessimistically. But it is hardly fair to blame the traders. You may as well know the breakeven levels are likely wrong, but if you have stop losses it is hard to fight all in. Similar in rates markets. Understandably,  the Sterling markets, with all Brexit talks warming up, are not very optimistic compared to Euro. But given the inflation difference and fundamentals, this is likely a mis-pricing too. At the same time, how long the USD 10y can maintain a 100bps+ differential to Euro rates without attracting yield chasers. The table shows three month forward curves across markets and the policy action priced in.

Today	EUR	GBP	USD	JPY
Current	-0.34%	0.51%	0.49%	-0.03%
Max	1.49%	1.88%	2.42%	1.42%
Long-run average	0.98%	1.27%	2.22%	1.26%
Next Hike	Mar-19	Mar-19	Jun-16	Dec-21
Initial Hiking Pace	8.3	7.4	6.9	4.5
Peak Time	Mar-29	Mar-27	Mar-33	Mar-34

Eventually all these will correct, may be sooner than later. But rather than being directional, it is time to see how to position for the volatility when we edge towards either extreme and the market overreacts. I would rather like to sit on gun powder now than trying to cover later.

I think this entire arguments and counter arguments are nicely captured in this Galilean dialogues from Gavyn Davis on FT.

For title reference see this and this.