Be vigilant and watch for vigilantes
Inflation shouldn't be disruptive this year, but watch for surprises to the upside.
The wait for higher inflation has been long and full of false alarms. The underlying factors of demographics, globalization and technology remain profoundly disinflationary. But as the U.S. economy emerges from the coronavirus crater, inflation likely will accelerate in the coming months—as will concerns it will run rampant. While we expect an uplift in price pressure this year, we don’t envision a disruptive level. Certainly not enough to prompt action by a Federal Reserve determined not to impair a broad and inclusive recovery. Nevertheless, investors should be vigilant lest inflation surprises to the upside.
The story might unfold with headline CPI climbing over the 3% mark in the next few months due to weak base effects in the comparable period last year and a robust rebound in real activity. GDP growth might reach as high as 6% for the year given continued fiscal support and the vaccine rollout. The rest would write itself: Businesses bounce back, bolstering employment and putting more money in the hands of consumers, many of whom have banked their stimulus checks.
When this ready cash meets pent-up demand, supply constraints could follow. How much this puts more sustainable upward pressure on CPI or PCE remains to be seen. It’s possible the economy, still in a deep hole due to the pandemic, will be able to absorb stimulus without pushing up prices. But that might not matter if the markets meet even a small upturn with exuberance.
History shows investors tend to overreact to positive developments. The chatter around the inflation outlook probably will get more intense as we approach midyear, setting the stage for a potential recalibration of market expectations around the Fed’s tapering schedule and the path of rate hikes. Furthermore, duration risk remains near a record due to years of near-zero rates and record debt issuance tilted toward longer maturities. That leaves bonds vulnerable if yields rise sharply, and there are plenty of bond vigilantes ready to pounce.
Portfolio managers and investors alike should prepare for this scenario or any other spike. With the Fed anchoring the short end and greater inflation risk premium at the long end, we feel a curve steepening bias with a short duration overlay to be the proper position. The potential for lower yields this year is quite low as we see sunny skies ahead.