US Inflation is rising and broadening. This is becoming a central political issue in the US. However, globally there are increasing signs of divergence in monetary policy stances, and in the pace of inflation surprises.
Inflation was again center stage in global markets last week, this time in the US, where consumer prices rose to the highest level in 30 years. Specifically, headline CPI increased 0.9% m/m while the core index rose by 0.6% bringing CPI to 6.2% on a y/y basis, the highest print since November 1990. While there was continued impact from the supply side, the October report showed broadening inflationary pressures, notably in rents where OER had the largest monthly increase since 2006. Our work on US housing over the course of this year led us to believe that the risk of a sharp rise in rents was underpriced, and this theme is now playing out.
The level and breadth of inflation caught the market by surprise and prompted a sharp move higher in front end US yields. Jun 23 Eurodollars had a 2.3x weekly stdev move higher in yield, but this actually understates the magnitude, as the move higher in yield on Wednesday post the data was in the 99th percentile of all daily moves in the last 10 years. This move in the front end and belly of the US curve precipitated further flattening in global interest rate curves, especially in developed markets and early cycle emerging markets, notably Polish 2s10s flattened by 28 bps a 2.1x weekly stdev move.
Chart: Jun 23 Eurodollar futures 1d change (lower = higher in yield). Move on 11/10 was the largest 1d increase in yield since 2016 and 3rd largest daily move observed in last 7 years
The impact of this level of inflation in the US is not to be underestimated. Politically, there is clear empirical evidence that inflation matters for voters, Joe Bidens popularity has fallen 42.7% in recent polling averages, its lowest point of the cycle and Fridays UniMich consumer sentiment data fell to its lowest level since 2011. Republicans are likely to blame this inflation on the Democrats' fiscal approach, and with Sen. Manchin’s recent comments, the political environment for passing another spending bill has cooled. It will also likely impact discussions around the next Fed Chair and would make a confirmation of Lael Brainard much more challenging.
With rising inflation being clear negative for the Democrats prospects at next year's mid-terms, there is a political imperative from the Biden administration to try to take measures to address this. Political pressure will continue to be brought to bear on OPEC, a SPR release is possible, but the fiscal policy toolkit is thin with respect to inflation outside of subsidy type payments, like we have seen already in France. We expect inflation to be a central political issue over the winter, and how the Biden administration is perceived as responding will have major implications for the shape of the next Congress.
However, even with some dominant macro trends in place right now, namely flattening and elevated inflation risk premium, there was much more divergence across markets than we have seen this year.
In rates markets we are beginning to see late cycle dynamics in some EM countries, which are well into their hiking cycles. Notably this week, Russian front-end yields had a significant move lower following a sequential easing in week-on-week inflation, even as DM yields were moving sharply higher. This move was unwound in part due to rising geopolitical risks in Russia, but it displays that where fiscal and monetary conditions are already very tight, the asymmetry is for lower yields once the rate of inflation eases. Similarly in Mexico, Banxico raised rates by 25bps but this was 25bps less than market pricing. Banxico are concerned about rising price pressures, but they can afford to be patient because of their tight fiscal policy stance and tepid economic recovery.
Finally, in China there was a strong rally in domestic property credits and equities, where the GS China real estate basket had a 2.8x stdev weekly move higher. This was driven by onshore and offshore media reports, which indicated authorities may ease regulatory conditions, alongside Evergrande paying two coupon payments. While these measures will not alleviate the broad macro slowdown that China is experiencing, they are positive signals and display the asymmetry in prices given the amount of negative news currently discounted.
Overall, this is a very interesting and dynamic macro environment. Our view remains in place, that inflationary pressures will keep risk premium elevated at the front-end of interest rate curves, especially in countries at the earlier stage of their rate hike cycle. We continue to be paid Polish rates and in flatteners there and in South Africa, with shorts in Eurodollars and 10y Treasuries in the US. However, there is an increasing set of alpha opportunities, especially in assets where risk premium has become acute, such as Brazilian and Chinese equities, and in interest rate markets where inflation and rate hiking cycles are peaking such as Russia and Brazil.
COVID Pandemic
World COVID cases increased again last week by +9.1% - the highest increase since the first Delta wave early August, with cases rising in Europe, CEEMEA, Latin America, and the US while falling in Asi. While cases fell for the week in China, the current outbreak is still notably elevated, widespread, and negatively impacting Chinese mobility. In CEEMEA, cases fell from their recent highs in Turkey and Russia, but case levels remain elevated in both countries. In Latin America, while cases generally remain low, some countries (particularly Chile) are showing a notable pick-up in new case growth.
Europe’s COVID wave continued to rise, with the region's cases approaching the heights seen last fall and early spring of this year. The European COVID wave continues to broaden and move from Eastern Europe to the west and south, with case growth in Germany, France, Italy, and Spain. In Germany, new cases hit the highest level of the pandemic, with 51,077 cases recorded on Wednesday. So far, the increase in cases has not translated into the levels of hospitalizations and deaths seen in prior waves due to the vaccination campaigns, as the chart on Germany shows below. While many recent restrictive policies have been largely focused on the unvaccinated, the European wave is increasingly leading to policy responses. On Friday, for instance, Netherland’s Prime Minister announced a partial three-we lockdown, while Merkel will meet next week to coordinate nationwide measures for Germany.
In the US, cases marginally increased by 0.4% for the week, with test positivity rates also rising from 5.1% to 5.3%. Given the backdrop of the rising seasonal European wave, rising positivity rates, and rising search volumes for COVID tests and symptoms, we anticipate US COVID cases will likely increase in the coming weeks. Some states, such as Colorado, are already struggling with rising cases, with reports of some areas in rural Colorado struggling with rising COVID hospitalizations.
Calvion’s View: Medium-term, we are constructive on the continued recovery from the pandemic, with the recent news on two successful antiviral pills representing a major breakthrough that will significantly reduce COVID related tail-risks for individuals and healthcare systems in the coming years. In the near-term, however, increasing European and US cases this winter represents a developing risk to the service sector recovery. While the recent decline in cases is encouraging in China, we still view risks as elevated due to how widespread the current outbreak is, and China’s continued adherence to strict zero tolerance measures.