Is inflation coming back?

Historically, the loudest signal of upcoming inflation has always been the slope of the US yield curve. This was seen as the best signal because the US treasuries market was—and remains—the most liquid in the world, and bond investors, ever sensitive to their investments losing value, was the fastest on the trigger.

Over the past 15 years or so, this classic signal has been somewhat devalued because inflation has appeared dead as a result of globalisation (the “China price”) and automation, both of which have reduced the ability of labour to negotiate for fairer terms. Indeed, this bias against labour has persisted despite the fact that rampaging capitalism has delivered multiple crises, each time being bailed out by ever more generous monetary policy, which has lit a seemingly permanent fire under asset prices.

This has increased inequality, as a result of which there has been a huge flow of funds into alternate investment vehicles, like private equity and real estate. These vehicles are not as sensitive to inflation, which may explain why the market is not—as yet—reacting to the rising slope of the yield curve as it would have a couple of decades ago.

Indeed, the difference between the 10-year and 2-year US treasury yields has been rising steadily since it briefly turned negative in August 2019. This despite the fact that the Fed pushed the entire yield curve sharply lower when the coronavirus hit (March this year) and committed to keeping short term rates close to zero for the foreseeable future. The 10-year hit 1% for the first time since March last week, and continues to rise; significantly, the spread itself has risen to 1% this week, its highest level since July 2017.

Other inflation indicators have also been on a straight ride up—the price of copper, for instance, has risen 60% since August last year, and other raw material prices are also surging. Oil, which always does its own dance, is also back to the level it was pre-coronavirus and looks like it could hit $65/bbl soon.

Perhaps, the most significant factor for the inflation outlook in the medium term is the structural change in the Chinese economy. Over the past few years as part of the US-China “trade war”, China has been moving away from being the world’s manufacturing centre for low-value goods to focusing on the higher end, higher technology products; this shift has been accelerated by the coronavirus, which compelled many, many global companies to look to shift production to other centres, both in Asia and closer to home.

Again, over the past five years or so, many young people in China are looking for more value for their labour—they are, perhaps, the first generation that is not steeped in the historic ethos of working hard without complaint. Thus, local costs are rising and the central bank has signalled as much in allowing a sharp appreciation in the yuan from 7.25 in May to below 6.50 today, a rise of nearly 10% in about eight months. In particular, there was a sharp (1%) appreciation on January 3, 2021, which suggests that this policy may well be on track to continue. So, if indeed inflation is set to rise globally—contrary, by the way, to what most analysts expect—what would be the implications for equity markets and the rupee?

Well, if most analysts end up surprised, equity markets will obviously also be surprised; contrariwise, many analysts are, in fact, beginning to warn of a pull-back—a few, in fact, looking for Armageddon. However, at least from an interest rate point of view, it is likely that the Fed will happily suffer (slightly) higher inflation than risk yet another trauma in equity markets. Then again, it is likely that over the next six months at the very least, the new US administration will—finally—focus on the only way to address America’s real problems and start using fiscal policy as a corrective for the years of almost criminally enabling capital. Thus, the near term for equities looks like volatility with a downward bias (at best).

Far more interesting is what will happen to the rupee. Clearly, RBI has been able to hold off the rupee’s year-end rally and the 73 target remains (mostly) unbreached. While vegetable price inflation has come down in December, there are concerns that prices may start to rise again, partly from global considerations and partly from expected increasing demand with the re-opening of the economy. Thus, it is hard to see interest rates coming down materially. This should continue to support the rupee.

However, oddly—and, perhaps, significantly—while foreign portfolio inflows are still positive, although down from the huge $8 bn that came in during December, debt inflows have turned negative (from a net inflow of over $700 mn in December, they are running at about $350 mn negative in January so far). Further, imports have started rising while exports remain underwater, all of which could bring some pressure on the currency.

Very hard to call; perhaps we will see the rupee continue to jockey around in a slightly narrower range—say, 72.50 to 74.00—with an upward bias.

The author is CEO, Mecklai Financial
Views are personal

www.mecklai.com