Bond Traders Are Flummoxed by ‘Slumpflation’

(Bloomberg Opinion) -- The world’s biggest bond market just doesn't know what to do with the prospect of an all-out trade war instigated by the U.S.

On one side, there’s a strong argument that tariffs among the largest economies will stifle the global expansion and push yields in the $15 trillion Treasury market lower. Those concerns are appearing in the price of copper, the industrial metal often viewed as a barometer of economic growth. It’s falling relative to gold at the fastest pace since August 2015. That ratio is frequently cited by DoubleLine Capital’s Jeffrey Gundlach as worth watching to assess the next move in interest rates. Right now, that direction would appear to be lower. 

However, as bond traders were reminded on Thursday, U.S. inflation is as strong as it has been in years. The headline consumer price index rose 2.9 percent in June from a year earlier, the quickest pace since early 2012. Core CPI is just shy of a post-crisis high, at 2.3 percent. That may keep the Federal Reserve on its rate-hike path and helps explain why Treasury yields haven’t moved significantly lower with the copper-gold ratio.

The combination of stagnant growth and accelerating inflation naturally conjures up the term “stagflation,” which bedeviled the U.S. in the 1970s. But, of course, that’s not quite right in today’s economy. The nation is still adding jobs at a blistering pace and the unemployment rate is near a 48-year low. Price growth, though at recent highs, is nowhere near the double-digit levels from that era.

So, then, what to call this new regime of potentially higher prices and weaker growth? Ian Lyngen at BMO Capital Markets suggests “slumpflation.” To him, one of the under-appreciated data points released Thursday is U.S. real average hourly earnings, which for the second straight month were unchanged from a year earlier. 

“While the Fed would love to see accelerating inflation as a function of greater real wage gains, the data has thus far been uncooperative in this regard. Higher tariffs which trigger inflation might fail to fit the traditional definition of stagflation - ‘persistent high inflation combined with high unemployment and stagnant demand’ - but it would present an issue for the Fed as it implies falling real purchasing power for a consumer-driven economy. For argument’s sake, we’ll call it Slumpflation.”

As Tim Duy wrote for Bloomberg Opinion, tariffs should be viewed as an across-the-board supply-side shock that raises prices and lowers output. That means their impact should be fleeting. But there’s reason to believe that the trade war hasn’t been reflected yet in the data: Core CPI came in at just a 1.7 percent annual pace over the past three months, the weakest in about a year. There might be room to climb further as pressures on shipping and trucking get factored in, and, as Duy points out, Fed Chairman Jerome Powell is likely to let the overshoot play out.

Taken together, this puts bond investors in a bind, explaining why U.S. yields and breakeven rates have been locked in a tight range for weeks. Copper has clearly figured out how to price a trade war. So have emerging-market currencies. But for Treasuries, there are too many competing forces to have a clear handle on the situation.

Traders seem content playing the ranges for now. With no one knowing exactly where the trade tensions will wind up, maybe doing nothing is the best strategy of all.

©2018 Bloomberg L.P.

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