Financial market signals of a deflationary pressure and consequences of the pandemic are expected to reduce; hence, it is expected that the inflationary pressures are making a come back.
Looking at the historical inflation rates and CPI levels in the US, it is evident that inflation rate had started soaring in the 70s. The tightening of monetary policy during the late 70s and early 80s might have stopped the inflation spiral, but evidently, it caused a severe recession. Based on lessons learned from history, over years, inflation has remained low during peace time and elevated during periods of war and hardship. During periods of peace and tranquility, trade and capital flows have led to globalization leading to more global competitions and a deflationary environment. Technology and innovation have boosted productivity and kept the lid on inflation. As fertility has dropped over years and the population aged, the aging demographics profile led to deflation. And finally, easy monetary conditions with respect to credit markets and easy credit conditions have led many companies to raise more debt at favorable rates. So much so that companies that are on the verge of bankruptcy or can hardly service their debt, called zombies, would continue to raise debt and stay in business, adding to the global goods and services which is also deflationary.
With the pandemic in the 2020 and Fed’s purchasing of treasuries in the market, federal deficits have been rising. Both M1 and M2 money supply have been increasing significantly in 2020. Interest rates have remained exceptionally low and companies and consumers have accumulated significant debt levels; however, inflation has remained low.
As the financial markets provide leading signals with respect to the performance of the economy, certain macro economic data discussed herein, signals the ending of the deflationary environment. This could potentially mean that inflation would be on the rise in the near future.
The first signal which is the proxy for expected 10-year inflation rate, is represented by the spread between the 10-year treasury yield and 10-year TIPS rate. As displayed below, both 10-year yield and TIPS rate have declined disproportionately, leading to the spread to rise to 1.92% as of December 09, 2020. The spread was standing at 0.49% on March 19, 2020 which was among the lowest points of the markets performance during the pandemic.
The second signal is the ratio of copper prices to gold prices. Copper prices have historically been correlated with expected inflation yield spread (40% correlation as of Dec 2020 given a 5-year historical data), while gold prices have been highly correlated with the inverse of TIPS rate with gold being a hedge against inflation. Hence the ratio of one month forward copper prices to gold prices (x times 10) points to the fact that the treasury yield should be closer to 2% as displayed below (1.94% as of Dec 12, 2020); however, the purchase of treasury yields by the feds have kept the lid on this inflation rate.
The third signal is the US dollar and its performance relative to other currencies. As we have noticed in 2020, USD has been weakening significantly against the basket of developed currencies.
As seen in the following graph, there has been a negative correlation between the price of copper and USD.
There has also been a negative correlation between the proxy for expected inflation and USD, displayed in the following graph.
With the weakening US dollar and given other signals above, all variables point to the end of deflationary pressures and potentially, a rising inflation rate.
In such scenario, if the inflation continues to climb, interest rates will increase more and as a result of the amount of debt accumulated by private and public companies during the easy credit cycles, interest expenses on those debts would significantly compound, leading to a credit crunch. This could potentially put stock markets into more difficult conditions and on the verge the bear territory.