Could U.S. be on its way to Stagflation?

It seems that for central banks, the lack of inflation is their only concern, but investors started fidgeting over the possibility of the wrong type of inflation- stagflation.

This concern arose from the carefully observed part of the bond market from which forecasts about inflation are derived, rebounded and was followed by a sharp increase in inflation expectations (1.2% for February for the next ten years to 1.7% since the fears over China last year). This event is also known as the ten-year inflation break even; it's caused between ordinary Treasury bond yields and inflation-linked yields.

At the same time as inflation forecasts reversed, Treasury yields turned in February, but inflation-based yields continued to decrease. This is important as buyers of TIPS (Treasury inflation-protected securities), are always looking for the safest return at the moment its 0.27% above inflation for ten years. The drop in yield might be suggesting a weaker trust in the economic growth of the country. At times like this, riskier assets increase their appeal.

One way of going about this is that the market is uncertain about the growth of the economy, in the midst of the rising pressure from growing oil prices and basic wages might cause the Fed to tighten its policy. This is not exactly like the stagnation which ended in 1980 with inflation hitting 15% amid a recession and the increase in unemployment. There is a possibility of a different type of stagflation called stagflation-lite which is caused by weak growth and accelerated inflation.

The member of the investment committee at Carmignac, Jean Medecin, further increased the fears stagflation-lite as he said that the Federal Reserve might be forced to normalize the rates because of inflation and at the same time when the economic momentum is slowing and isn’t capable of taking higher rates.

The United States economy, for the past five years, has been driven by consumers and consumer stock are showing that caution reigns. According to Merrill Lynch, the yield on junk bonds compared to Treasury’s has decreased to 6.7% from 7% since the beginning of 2016. This is probably caused by the fear from widespread defaults by energy companies.

The increased demand for gold does not lower the concern as much, because even if it is the best protection against inflation, it does not have income and always tends to move in the opposite direction of TIPS yields, which also can be seen as the revenue is given up to hold gold. All TIPS fell, so it is normal for gold to rise.

Increasing oil prices are the wrong sort of inflation for growth. While some asset prices may be forced as more expensive, oil removes the risk of defaults on financial dislocations. But this might be considered as just noise around the overall negative economic market signal.

Also, it is hard to expect that nominal bond yields will rise when ECB and BoJ are forcing negative yields on bonds. Treasury yields are held by the pull of negative yields in Japan and Germany, even if there is some increase in U.S. Inflation there is a limit on what we can see on ordinary Treasurys.



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