It’s been some time since the market had to digest the potential return of inflation. Not long ago, a starkly different narrative was dominating the market discourse: deflation. However, since the results of the U.S. election became known, market participants began to shift their focus to what has been anointed the “Trump Reflation Trade.”
Simply put, the logic behind this “trade” is that fiscal stimulus (i.e., government spending) will now take the baton from monetary policy (i.e., interest rate policy), and provide a new impetus for economic growth, spurring elevated inflation readings and expectations. Initially, financial markets appeared to buy into this line of reasoning, as the S&P 500 rose +10% in the wake of Election Day, while the U.S. Treasury (UST) 10-Year yield climbed about 65 basis points (bps) during the rally (S&P Capital IQ). We’ve seen a slight retracement in both equity prices and yields as the narrative has stalled.
The most widely followed inflation gauge is the Consumer Price Index (CPI). This monthly report is released by the Bureau of Labor Statistics (BLS), with both the overall and core (excluding food and energy) readings receiving the most attention. Last month’s CPI report revealed that overall inflation rose at a year-over-year rate of +2.7%, the highest in almost five years. This compares to the 2016 low point of +0.8% in July, and the outright negative readings less than two years ago. Certainly, the rebound in energy prices from the levels witnessed a year ago played a role in this unexpectedly elevated reading, but perhaps more importantly from the Fed’s perspective was the core measure (CPI minus food and energy) maintaining its upward trajectory. Indeed, core CPI rose at an annual rate of +2.2%, and has now posted a reading of +2.0% or higher for 16 consecutive months. Coupled with the best wage growth since 2009, the stage has been set for higher inflation expectations.
The Fed has responded accordingly, as illustrated by its “pushed-up” rate hike at the March FOMC meeting. Certainly, one of the key reasons behind this latest tightening move was the fact that inflation was on the verge of hitting the Fed’s target threshold. The Fed’s preferred measure for inflation is the price index for personal consumption expenditures, which itself has also been on an upward trajectory: last month’s +2.1% reading also bodes positively for future hikes.
Markets will be glued to additional wage and inflation data over the coming quarters, and we’ll continue to keep a close eye on our fixed income holdings to ensure an appropriate response to rising rates. In the meantime, we’ll all be more susceptible to declining purchasing power.