Earlier this week, we learned that US inflation rose much more dramatically than expected in July.
Core inflation (the consumer price index – CPI – but with all the volatile stuff like food and energy prices taken out) jumped by the most in nearly 30 years.
In context, the actual figure isn’t particularly dramatic. Core CPI was up 1.6% year on year, hardly hyperinflation.
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But is this the shape of things to come? And what would that mean for investors?
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Something strange is happening in the US bond market
The yield on ten-year US government bonds (Treasuries) has remained pretty stable over the past few months, up until this week at least (and even then it’s only hit an eight-week high).
However, inflation expectations have picked up sharply during the same period. This, as Albert Edwards of French bank Societe Generale points out, “is most unusual”.
Why’s it unusual? Like most bonds, a ten-year US government bond – an IOU from Uncle Sam – pays a fixed amount of interest. If inflation goes up, that fixed payment becomes less desirable. As a result, the price you are willing to pay for said bond should go down, and the yield should go up.
(The yield on a bond is simply the interest payment on the bond, expressed as a percentage of its price. Think of the price and the yield as opposite ends of a seesaw).
To put the same thing slightly differently: let’s say that at the coronavirus low in March, you expected inflation to come in at less than 1% a year. But since then, you have seen all the money printing by central banks and governments. You now expect to see future inflation at closer to 2%.
Given that change in expectation, should you be willing to pay pretty much exactly the same price for the ten-year US Treasury as you were back in March? If you were willing to accept a yield of around about 0.6% in March, should you be perfectly happy to accept 0.7% today?
No, absolutely not. You should want a significantly higher yield, which means you should be willing to pay a lot less for the bond – because you expect inflation to be a lot higher and so to erode the value of your investment.
The result of all this is that real yields (in other words, the yield you get after taking inflation into account) have fallen in the last few months. This, in turn, has helped precious metals in particular.
So who’s right? The bond market? Or inflation expectations?
Edwards is still not convinced that we’re going to see higher inflation. He reckons that the upwards jump in inflation in July is partly because a slide in rental costs hasn’t yet fed into the data.
And he may well be right – measuring anything officially at the moment is a lot trickier than normal given both the lockdown and the rates of change.
Investors are pricing in financial repression
That said, it’s little wonder that households are starting to expect higher inflation, because Covid-19 has in effect imposed higher prices on most of us through its impact on our lifestyles. As a piece on Bloomberg by Shuli Ren yesterday pointed out, inflation may well be “a lot higher than you think”.
Why? Alberto Cavallo of Harvard Business School (Cavallo is also behind The Billion Prices Project, which tries to collate and analyse inflation data in real time) has just written a paper on the topic.
The issue is that Covid-19 has changed our habits so that the average official inflation “basket” – which tries to measure the lifestyle of the “average” consumer – is now completely out of whack with real life.
For example, right now most of us aren’t travelling half as much. But we are shopping an awful lot more. In the US, the official basket is split 8% groceries, and 15% transport. That’s no longer at all representative – by looking at credit and debit card data, Cavallo reckons it should be more like 11% groceries, 6% travel.
This sort of disparity is not limited to the US. Cavallo reckons there are similar issues – where the “Covid inflation” rate is higher than the official consumer prices index rate – in ten out of 16 other countries he examined, including here in the UK.
There’s an element of “well, so what?” to this. Inflation measurement is an imperfect science at the best of times.
But if expectations matter – and economists and central bankers are always telling us they do – then the fact that people think prices are rising faster indicates a change in psychology that could also lead to the velocity of money accelerating.
And in the longer run, it’s worth noting that there isn’t necessarily a contradiction between low bond yields and rising inflation expectations. If investors expect central banks to keep interest rates nailed to the floor – in other words, they’re betting on financial repression – then that would help to explain the disparity.
At some point, of course, investors will test central banks’ mettle. They’ll need convincing that the Federal Reserve and its peers are willing to “do what it takes” to keep rates low, even if investors start to run for the hills. That’s probably when we’ll start to see the next bout of nerves in wider markets.
But I suspect that it won’t take much in terms of a drop in stocks or a rise in yields for central banks to crack down sharply.
This is one reason why I’m comfortable with the idea that the precious metals bull market has a way to run yet. We have more on that in this week's issue of MoneyWeek, out today. Dominic Frisby talks about the next potential moves for gold and also looks at some of his favourite precious metals mining stocks. If you’re not already a subscriber, sign up now to get your first six issues free.
