Having recovered steadily since March, investors’ expectations for inflation over the next ten years are now roughly where they were before the corona virus pandemic struck – or are they?
A Bloomberg Opinion article published earlier this week argued that this is a mirage. The piece made two basic claims. The first is that the swings in bond market breakeven inflation recently have in large part been caused by changes in the relative liquidity of TIPS and conventional Treasuries. In other words, relative demand for TIPS and Treasuries has been influenced at least as much by market conditions as by perceptions about the inflation outlook.
The second – citing a model produced by Fed staff that tries to strip out these liquidity effects – is that “true” inflation expectations have not recovered at all since March, leaving them well below pre-pandemic levels.
The first claim is not especially contentious. During the market distress in March, it is clear that liquidity was hard to come by in both TIPS and Treasury markets, but to a much greater extent in the former. As in late 2008, when Lehman’s large holdings of TIPS were reportedly unwound, that clearly had a big impact, exaggerating the decline in breakeven inflation (the gap between Treasury and TIPS yields). We pointed this out back in March. Since then, liquidity has returned to both markets, presumably helping that effect to unwind.
However, the second claim, that true long-term inflation expectations are still much lower than before the pandemic, is less convincing to us. To understand why, if we ignore the uncertainty of future inflation, breakeven inflation can be decomposed into true inflation expectations minus a liquidity premium for TIPS. This is the extra compensation investors require for holding less-liquid TIPS rather than Treasuries.
10-year breakeven inflation is now where it was before the pandemic. So if true inflation expectations are lower than they were then, the liquidity premium of TIPS must also be lower. That would mean that what happened in March has more than unwound.
Liquidity is a slippery concept, which can be measured in many ways. But we struggle to see that perceptions of it have improved a lot for TIPS vis-à-vis Treasuries since before the pandemic. Since March, conventional measures of liquidity, like bid-ask spreads, have mostly just returned to around pre-pandemic levels in both cases. With that in mind, we think that long-term inflation expectations probably have rebounded, recovering with markets generally. Even so, they are still well below levels that would worry the Fed, especially given its ongoing shift in attitude towards inflation. (Oliver Jones)
Key Data & Events
US
The further decline in the Conference Board consumer confidence index in August can be at least partly explained by the expiration of enhanced unemployment benefits at the start of the month and suggests the pace of monthly consumption growth is likely to slow further. That said, the scale of the rebound in May and June means that consumption is still set to surge by at least 30% annualized the third quarter overall. Residential investment could be set for an even sharper resurgence. New home sales jumped to 901,000 annualized in July, the highest level since 2007. That illustrates the big boost to demand from the plunge in mortgage rates this year.
The July durable goods data due on Wednesday are likely to show a small rise in core orders of about 2% m/m, in line with the gain in manufacturing output already reported. But that would still suggest that business equipment investment is also set for a big rebound in the third quarter. (Andrew Hunter)
Europe
The second estimate of Germany’s GDP in Q2 confirmed that all components of domestic demand except government spending fell sharply. While the Statistics Office revised down its estimate for the contraction in Q2 from 10.1% q/q to 9.7%, this is still the largest fall recorded since the quarterly GDP series was launched in 1970. We expect a big rebound in Q3, but survey evidence, including from the Ifo Business Climate Index, which was also published on Tuesday, suggests that the recovery is slowing. The index rose in August but remained below its pre-crisis level and is consistent with GDP in Q3 remaining lower than in 2019 Q3.
Elsewhere, while Sweden’s light-touch response to COVID-19 has hogged the headlines, data released on Tuesday showed that, after contracting by 6.3% q/q in Q2, Norway’s economy outperformed its Nordic cousin in the first half of the year, and will probably contract by less than Sweden’s economy in 2020 as a whole.
In a quiet day for data on Wednesday, we will be watching out for comments from ECB Executive Board member Isabel Schnabel when she participates in panel discussion at the Annual EEA Congress. (Melanie Debono)
Other Emerging Markets
In Emerging Europe, Hungary‘s central bank kept its base rate unchanged at 0.60% on Tuesday. We think that further rate cuts are off the table, but if the rise in core inflation to a fresh 12-year high proves long-lasting and the forint depreciates, the likelihood of interest rate hikes will grow.
In Latin America, the further rise in Brazil’s inflation to 2.3% in the first half August was relatively small and we expect the headline rate to remain well below the central bank’s 2020 target of 4% over the coming quarters. That said, recent political events and renewed jitters about Brazil’s fiscal position have raised the bar for additional interest rate cuts over the coming months.
In Sub-Saharan Africa, figures due out on Wednesday will probably show that inflation in South Africa rose from 2.2% in June to 2.8% in July. However, we still think that the country’s central bank will deliver further interest rate cuts over the coming months to prop up the ailing economy. (Liam Peach, Edward Glossop & Virág Fórizs)
Editor: John Higgins