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Albert Edwards is back – back, that is, from his annual search for January sun to counter the effects of Seasonal Affective Disorder (SAD).
And the sojourn looks to have been partly successful. Obviously the Soc Gen strategist remains bearish — he reckons the long-term downtrend in 10-year bond yields is under serious threat. But this could present investors with an opportunity for some bottom fishing, says Edwards.
Here’s why.
Regular readers will know that we have often noted that core inflation tends to fall most in the early phases of economic recovery (see chart below), not, as most expect, in a recession. The reason is very simple. At the early stages of the recovery, productivity growth rises rapidly, driving down unit labour costs and giving companies the opportunity to cut prices. Later on in the cycle, unit labour cost pressures tend to rise, putting cyclical upward pressure on inflation.
Sure, enough core US CPI inflation has undershot the market’s most worrisome expectations over the past year or so.
And here Edwards’ key point. (Emphasis throughout ours).
I would now expect core inflation to begin its normal cyclical uplift as we move deeper into the economic cycle. And given the jitters that abound about the impact of QE on inflation, I would expect the markets to over-react to these developments. Many market participants who believe an inflation take-off is just around the corner will then have more evidence to berate Central Banks for being well behind the tightening curve.
Our own US economists have just done an excellent review of the imminent end of disinflationary trends. They note, in particular, that the rent element of the CPI (both actual and imputed), after slumping into outright deflation, has begun to rise once again (see left-hand chart below). As well as being a weight of 30% of the overall CPI, ‘rent’ comprises a hefty 40% of core CPI (ex food and energy). Our US economists believe the current cyclical uplift that rising rent inflation should be having on core inflation is temporarily being offset by erratic downward moves in goods inflation that will be reversed shortly . A series of 0.3% rises in core CPI inflation will seriously threaten the long-term downtrend in 10y bond yields (see right-hand chart below). Any decisive break above 4% is likely to trigger a melt-up in yields which will in retrospect prove to have been a total over-reaction to what are normal cyclical trends. Therein lies the near-term risk, but also the medium-term opportunity.
And that near-term risk would be?
Our US economists believe that an additional factor which will drive core CPI up is that higher Chinese inflation is about to ripple onto US shores. Higher Chinese CPI inflation is set to feed through into higher Chinese import price inflation as wages move upwards in China – our economists note a four-month lag (see left-hand chart below). US goods inflation could be set to rise sharply in reaction to higher Chinese inflation (see right-hand chart below). So, despite Ben Bernanke’s firm denials that QE is not responsible for higher global food prices and hence higher Chinese inflation, to the extent that he is totally wrong (surely not!), the Fed’s QE policies are likely to have a ruinous effect on both bond and equity prices in the near term.
Just a ruinous sell-off, then. Oh happy days.
Related link: Waltzing towards the next, inevitable implosion – FT Alphaville
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