Inflation expectations – how soon will it materialise

Safe haven bond yields serve as a key checking point for investors, not only in the bond market but for the overall financial market outlook. US treasury yields have reached the highest level since the start of the pandemic, fuelled by economic growth expectations. Implicitly, inflation and interest rates are also expected to rise on the back of a stronger economy. The key question, therefore, is when do the rise in safe haven yields become a concern for equity investors.

The sharp drop in yields and the bottoming of the stock market last March, represented the significant economic contraction brought about by the covid-19 pandemic. Since then, the unprecedented level of monetary and fiscal stimulus that followed, fuelled the start of the current economic recovery. The low interest rate and inflation environment, together with the discovery of effective covid-19 vaccines, has led to a strong rally in equity markets and an up shoot in equity valuations. High growth companies are trading on historically high multiples relative to earnings, reflecting an improvement in earnings growth expectations, that is typical at the start of an economic cycle.

In the bond market, the US 30-year treasury yield briefly breached the 2% level while the 10-year Treasury reached the 1.2% level. Although still historically low, yields have moved distinctly higher when compared to the 0.5% level in March. Apart from the change in yield levels, news of the covid-19 vaccine discovery triggered widening in spreads between long and shorter dated bonds, changing the slope of the yield curve. The movement towards a steeper curve is also indicative of stronger economic activity and rising inflation expectations.

Changes in inflationary expectations are best reflected across break-even rates. Break even inflation rates measure the difference between a sovereign bond and an inflation-protected bond of the same maturity. Therefore, the ten-year breakeven rate indicates the market implied inflation expectations for a ten-year time horizon. Regional inflationary expectations have diverged significantly during the past months. The US 10-year break-even has moved above pre-pandemic levels to 2.2%, whereas Germany’s 10-year break-even rate stands at 1.09%. Relatively speaking, expectations for the US are more bullish when compared to Europe.

The recent uptick in yields and break-even rates is largely driven by concerns that the additional $1.9 trillion stimulus proposed by the Biden administration, will overheat an economy that already shows signs of improving and outperforming other regions. The strong corporate earnings season in the US currently underway is further proof that the recovery in sales and earnings growth occurred sooner than expected. With the majority of companies already reported earnings, this quarter earnings season shows that in aggregate, US companies recorded a positive sales growth surprise relative to expectations and managed to beat earnings expectations. This contrasts strongly to the relative weak earnings momentum recorded in Europe.

Fundamentally, on the back of improvement in growth expectation, bond yields and inflation expectations are expected to rise over the coming months. The key takeaway, therefore, is the speed at which inflationary pressures kick in relative to expectations. A faster rise in inflationary pressures would also force interest rates to rise sharply.

As evident in last week’s US’s core inflation data, which stood at 0% and below market expectations of 0.2%, inflationary concerns are not yet an imminent concern. Federal Reserve Chair Powell also squashed concerns over premature tapering, and highlighted that the Federal Reserve’s Average Inflation Targeting approach will accommodate an annual inflation target above 2% before interest rates start to rise. Nevertheless, given the higher debt levels since the start of the pandemic and the sharp rise in equity valuations, investors in risky assets must stay cautious if yields continue to accelerate.

Disclaimer:

This article was written by Rachel Meilak, CFA, Equity Analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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