Stagflation Fears Are Excessive If Break-Even Curve is Right

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Calls that stagflation is returning are premature, according to rates markets.

Traders are still anticipating price pressures to peak only moderately higher in coming years and subside over the longer term, based on five- and 10-year break-even rates. Market players also question how long the strongest consumer price index gains in around 40 years will last, pointing to some key differences between the current situation and the oil supply shock in the 1970s. 

“In a stagflation environment you see inflation, you don’t see growth,” said Sarah Shaw, chief investment officer at 4D Infrastructure Pty in Sydney. “We are also seeing huge amounts of pent-up consumption demand, huge amounts of stimulus programs that are sitting in deposits and still haven’t flowed through to the economy.”

“Huge amounts of that stimulus are in an infrastructure build-out that has massive growth multiplier potential,” she said.

The 1970s energy crisis that led to stagflation featured rising unemployment, stumbling growth, and a Federal Reserve bent on aggressive interest-rate hikes. None of these are identical today. The U.S. jobless rate is just 3.8%, while growth is recovering from a brief recession. While the Fed is planning the first of what’s likely to be a series of rate hikes next week, Chairman Jerome Powell has stressed that policy makers will move carefully.

Read More: Summers Says War, Excess Stimulus Raise 1970s Stagflation Risk

“Rates markets appear to be pricing the inflation impact of an oil shock as temporary, in contrast to the 1970s,” Praveen Korapaty, chief rates strategist at Goldman Sachs Group Inc. in New York, wrote in a client note Tuesday. At that time, the expectations curve inverted on a supply shock, but flattened as that shock spilled into an expectation for more sustained inflationary pressure, he said.

“Inversion back then was likely also driven by anticipation that policy would have to be tightened substantially to lower inflation. With medium-term inflation expectations still apparently anchored today, markets may not show the same urgency in pricing an aggressive Fed response.”

Only 3%

Market-implied expectations for inflation over the next decade are the highest they’ve been since 2005, but they’re still only pointing to a consumer price index running around 3% over the next decade. CPI peaked above 13% in the stagflation era, compared with an annual rate of 7.5% in January. 

The inversion of the break-even curve also argues that the run-up in inflation won’t be a long-term one. The 10-year break-even rate is a record 60 basis points below the five-year gauge, the widest gap recorded in data compiled by Bloomberg.

All of this isn’t to say investors should be complacent about the threat that inflation poses to their portfolios, according to Shaw at 4D Infrastructure.  

“With inflation coming back people should be rethinking how they look at their portfolios to hedge some of that risk and some of the best ways to do that are infrastructure,” she said.

©2022 Bloomberg L.P.

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