If There’s No Inflation, Then Why Do Inflation Expectations Keep Going Higher?December 15, 2020
Last week we commented that despite the very tame CPI reading, alternate measures of inflation were telling a different story. Chief among them are inflation expectations as priced by the Treasury bond market. Well, this week we again got another inflation data print that showed a rather subdued inflation backdrop. The import inflation price index came in at 0% MoM while expectations were for a rise of 0.2% MoM, so it was a decent size “miss”. And yet, inflation expectations across the short to intermediate legs of the yield curve are hitting cycle highs again. Moreover, the message from the most inflation sensitive assets is confirming the message from inflation expectations.
This setup reminds us of the Groucho Marx/Richard Pryor line, “Who you gonna believe, me or your lying eyes?”
As the reader can see, despite the import price inflation miss, 2-year breakevens continue to march higher and higher.
Along with those inflation expectations, small stocks are outperforming big tech. Small stocks tend to be more sensitive to changes in inflation than larger firms. Big tech companies are also notoriously volume monetizers, meaning incremental margin is acquired through volume gains rather than price increases. That’s why our small cap to big tech ratio is so important in the context of confirming inflation expectations.
We are getting similar confirmation within stock market sectors. Materials companies are outperforming consumer staples companies right on queue with inflation expectations rising. Here again, basic materials companies tend to be more inflation sensitive than staples firms since markups in raw materials prices directly feeds through to higher margins (i.e. operational leverage).
Finally, the copper to gold ratio is telling us the same thing, that the bond market’s inflation expectations aren’t operating in a bubble. Many investors think of gold as an important inflation hedge, but the reality is that copper actually outperforms gold when the bond market sniffs inflation, just as its doing today.
So who are you going to believe, the inflation indexes or the bond market? And, does it even matter? Financial asset prices are clearly choosing to believe in the bond market’s take. Fighting that trend and following the “message” from the inflation indexes has been expensive. We suspect it will remain so.