US government bond yields ticked up yesterday on what CMC Markets termed “growing chatter” about the likely impacts of inflation over the short-to-medium term.
Markets took note. Equities were weaker generally, although those with an in-built inflation hedge, like the major miners, were stronger.
Co-incidentally, UK inflation numbers were also out on the same day, coming in higher than had been forecast, although since the latest numbers are just monthly, it’s hard to discern a trend.
Nonetheless, analysts in Berenberg took the opportunity to draw the attention of investors to the broader context, and some likely ways that current monetary policy might play out.
“After four decades of declining inflation the tide is turning in the advanced world,” said Berenberg.
“Several cyclical and longer-term structural factors suggest that underlying inflation will rise in the coming years. Markets have begun to sniff out the increase in price pressures.”
Berenberg reckons that once the impact of the pandemic starts to to fade, the extent to which inflation will rebound and the reaction by central banks to it will turn into the top issue for markets.
Whether that will be good or bad is a more nuanced point.
“A gradual return of inflation to central bank targets of around % can be neutral or even mildly positive for the economies and real assets such as equities,” continued Berenberg.
“Central banks could then slowly scale back their stimulus without jeopardising the economic recovery. However, a sustained rise in inflation beyond levels that central banks are inclined to tolerate would force them to step firmly on the brakes eventually. High financing costs and the subsequent plunge in economic growth would be a recipe for a major selloff in equity markets.”
The broker also talked about an eventual return to normality, meaning not the normality that prevailed before the pandemic, but the normality that prevailed before the Lehman Brothers collapse in 2007.
On that paradigm, inflation would be less subdued than it has been in recent years, and there would be faster gains in GDP per capita and productivity as well as higher central bank rates and bond yields.
But Berenberg also points to a tail risk – a possible return to the disasters of the 1970s, although as it stands, that’s not the most likely scenario.
The inflation and growth outlook resembles the 1994-2007 period and represents a major improvement over the past decade,” the broker said.
“While some observers worry that the future will be more like the high-inflation 1970s, we do not see this as a serious risk. Central banks will not repeat that mistake.”