Inflation Signals Expansion

Concerns about imminent inflation have surfaced among the investor community over the last year as a result of the Fed’s aggressive monetary policy. In our monthly market update, we mention that we do not believe fear of inflation was behind the recent rise in bond yields. This post seeks to explain why increasing yields are an indication of the bond market’s belief that the economic recovery is real and sustainable.

Some investors point to the Consumer Price Index (CPI) as an indicator for inflation. What may come as little surprise to those who have spent much time in their grocery stores and gas stations over recent months is the greatest year-over-year price increases seen within the consumer basket have been in food and energy, which is why many believe inflation is now here. However, recent history (i.e., since 1990) demonstrates that treasury yields are more correlated with the CPI excluding food and energy prices than the overall CPI (Figure 1). As a result, recent price inflation in the food and energy categories would be breaking precedent were they to be the driver of the recent bond market moves.

Figure 1. Treasury Yields are More Correlated with Price Inflation Excluding Food and Energy

Source: St. Louis Fed and Balentine

Source: St. Louis Fed and Balentine

This phenomenon makes sense to us because of the nature of the business cycle, described in our 2019 Capital Markets Forecast. Each of the phases listed is associated with some level of price change:

• expansionary phases typically experience inflationary pressures.
• contractionary phases tend to feel deflationary pressures.

This is not always the case, as the late 1970s demonstrated inflation during recession, but more often than not, the cycles will unfold this way.

As such, inflation in the beginning of an economic expansion is quite normal, as companies begin to experience pricing power on the rebound in consumer and corporate demand.

This inflation is not of the pernicious variety that triggers fear in many who lived through the late 1970s, but rather a normal reversal of the deflationary pressures felt late in the preceding contraction, which the U.S. economy experienced in the middle of 2020. Bond rates follow suit in moving higher as the economy expands; where the bond market gets concerned is when the economy is encountering inflation and overheating many years into an expansion, which is clearly not the case this time given a recession that is only several months in the rearview mirror.

Beyond the impact specifically on bond yields, there is a broader discussion to be had on inflation. Read more about how it affects investment portfolios in this blog post.