Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Saxo Inflation Monitor
Christopher Dembik
Head of Macroeconomic Research
Summary: Saxo Inflation Monitor is a new publication that tracks various forms of inflation and price trends in order to forecast the evolution of inflation and the potential market impact.
We intuitively believe that the rise in protectionism is fueling higher inflation. While there is evidence of price spikes on products targeted by higher tariffs (such as the price of washing machine imports in the United States), aggregate inflation remains low in most developed countries and even falls in many Asian countries.
The latest Chinese figures tend to indicate that China is starting to export lowflation globally again. Chinese CPI for non-agricultural products is up only 1% YoY while the PPI is collapsing to minus 1.2% YoY from minus 0.8%. The outlook is not as bad as in 2015, when China has massively exported deflation to trade partners, but should economic situation continue to deteriorate, the risk of outright deflation would increase significantly.
In the United States, the main measures of inflation confirm that it is close to target. Based on an annual percentage rate, CPI is standing at 1.7% YoY in September, PCE is at 1.6% YoY in August and PCE excluding food and energy is at 2.4% YoY the same month. Inflation is notably supported by a healthy job market and still improving wage growth.
However, these drivers may play a less important role in the coming months. In the chart below, we have plotted small businesses' plans to increase compensation, and the evolution of the employment cost index, which details the changes in the costs of labor. We find out a strong correlation of 0.8 between both series and that NFIB compensation plans lead by three quarters.
Based on the latest update, the net share of small companies planning to raise compensation in the next three months is moving downward, at 18% in September (down 7 points from the peak of this cycle reached in November 2018). It tends to suggest that inflationary pressures are slowly fading on Main Street and it could ultimately result in lower employment cost going into 2020.
The divergence between realized inflation and expected inflation has increased a lot over the past few months. The University of Michigan survey, the 5-year break-even inflation rate (chart below) and the Cleveland Fed survey all confirm an increased risk of de-anchoring of inflation expectations. The 5-year break-even inflation rate is close to its 2015-2016 low points when inflation was moving down due to the Chinese deflation. This divergence is intriguing because inflation expectations should normally be higher given the current headline inflation and commodity trends.
The evolution of the Fed’s “underlying inflation gauge” confirms that inflation expectations are going in the right direction and that inflation is doomed to fall in 2020. In the chart below, we show the relationship between core CPI and the new underlying inflation tracker of the NY Fed that integrates both macroeconomic data and financial variables (if you wish, you can access the full data set HERE). Not only does the “underlying inflation gauge” demonstrate high correlation of 0.7 with core CPI, but it also leads the former by a little over a year. This correlation suggests that inflation may be about to deceleration, which could be good news for the FED as it would leave more room to lower rates further to stimulate the economy.
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