So, this rise has been driven more by rising inflation expectations than rising real growth expectations, although there has been some of both. But last week’s 14 basis point rise in the nominal rate was all about inflation – TIPS yields were unchanged. The weak employment report last week got all the news but the bond market was focused like a laser on average hourly earnings and the potential that has for inflation. The difference here is not large and inflation expectations at the 10 year time frame are still just 2.5%. That is higher than I’d like but compared to the last 20 years is not extraordinary.

10 year Breakeven inflation rate and the inverse of the broad dollar index:

I think there is a question though as to the direction of causation. Does a weak dollar create inflation or does inflation cause the dollar weakness? I think we all think back to the end of Bretton Woods and think it must be the former but I’m not at all sure about that. During the Bretton Woods era inflation fluctuated pretty wildly after WWII (10% in 1948) as the Fed held rates low to keep interest costs on the war debt low (sound familiar?). The dollar didn’t move because exchange rates were fixed but if it could it probably would have since the Fed kept rates from doing so. And inflation did rise from roughly 1% in 1965 to over 6% by 1970 and the pressure on the dollar eventually pushed Nixon to break the peg to gold in August of 1971.

The rise in rates is not confined to the long end of the curve as the 2 year yield is rising too but the long end is rising faster so the yield curve is also steepening. There is still quite a ways to go if the curve is going to steepen to the point it has after the last few recessions:

While the current inflation rate may not be sustainable (if the dollar stays strong) that does not mean the current price hikes will be reversed once the supply chain is cleaned up.

Average hourly earnings in the latest employment report were up strongly, 0.6% for the month and 4.6% year over year. But real average hourly earnings (after inflation) were not, up just 0.1% for the month and down 1.1% over the last year. Even if this inflation is “transitory”, companies are going to do their best to retain the price hikes of the last year. Commodity prices should be an exception but environmental policies are making that less likely. The push for net zero emissions from traditional energy companies means they aren’t investing to discover new reserves. Banks have been pressured to not lend to fossil fuel companies and the Fed is being pressured to make that more than a suggestion through capital requirements. That is the obvious implication of adding a climate mission to central banks remit. There’s a reason oil and natural gas prices are where they are and I do not expect the supply side to get better anytime soon. And reducing demand isn’t merely a matter of building more windmills and solar farms as Europe and the UK have discovered to their citizens dismay.

The inflation we see today is a consequence of past policy choices but I don’t mean, necessarily, monetary policy. Our response to this pandemic was straight out of the demand side recession playbook. Unfortunately, it wasn’t a demand led recession but rather a supply shock (mostly). It should not be surprising that prices are rising. Stimulating demand before the supply side recovered was a recipe for disaster and here we are. I suppose the pandemic response may have reduced the pain of the recession and it may have even reduced the depth of the economic loss. But there are no free lunches in this world and the cost will be measured in the recovery. We entered the pandemic with a trend growth rate of 2.2% over the previous decade. Higher prices and a large addition to our debt load point to a future trend growth rate that is even lower.

Whether that scenario comes true or not depends on a lot of factors that we can’t predict so it isn’t inevitable. In fact, I think there are hints that pandemic induced changes may well prove economically beneficial. The future is, as always, unknowable but it is surely going to be interesting.

For now, because the rise in rates is being driven more by inflation fears than growth hopes, I will not change my characterization of the current economic environment. We are still in a slowing growth, rising dollar environment:

It’s a pretty big week for data with more information on the labor market via the JOLTS reports and a slew of inflation indicators. We also get a preliminary look at Consumer Sentiment which has not been all that positive recently.

The value indexes though did perform well last week especially at the small and mid cap levels.