Mizuho Daily – Mercury Rising | US Inflation Concerns Premature, if not Misguided

Mizuho daily insights by Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

Mercury Rising

Reflation continued to be the dominant theme asserting itself as a cocktail of higher commodity prices, loftier yields and cautious retreat/reallocation in equities. Whether Nasdaq’s 2.5% drop is merely a rotation (out of tech into cyclicals) amid reflation is debatable, with S&P500 down 0.8% but Dow eking out a 0.1% gain. But there is little doubt that reflation boost to Commodities (notably Oil, industrial metals) is cause for re-allocation in equities as Energy and Materials sectors (S&P500, Dow) lead gains. What’s more, a steeper yield curve as a consequence of long-end yields leading the rise from reflation also reinforced the out-performance in Financials.

Admittedly, Brent Crude pushing past $65 and WTI flirting with $62 are accentuated by, if not largely owed to, the deep freeze in Texas impacting rigs and Shale alike. But the wider point is that an exceptional drop in US temperatures is not the driver of markets at large. Instead, mercury rising with respect to reflation is. Especially as a concoction of monetary and fiscal stimulus sets forth a potentially frothy deluge of cash. Bond markets are in the thick of the reflation wave; with 10Y UST yields flirting with 1.4% before easing back a tad (albeit still above 1.36%) while 30Y UST yields are nearing 2.2%. It appears that 1.5% is a psychological level that markets may have tempted to test back towards ~1.75% pre-COVID levels that was seen in January 2020 (before the Wuhan lockdown).

Even ECB President Lagarde jawboning with allusion to “closely monitoring the evolution of longer term nominal bond yield” merely dampened, but did not deter, yield buoyancy.As mercury rises on yields, whether “Twist” type of policy response will be elicited to dampen long-end yields remains the elephant in the room. Meanwhile, reflation is reining in USD; EUR bumped up above 1.21, AUD above 0.79, USD/JPY at sub-105 and USD/SGD testing 1.32. But mercury rising on reflation is not necessarily a prelude to runaway inflation.

Why US Inflation Concerns are Premature, if not Misguided

In some camps, unprecedented monetary policy stimulus alongside record stimulus is raising alarm about pipeline inflation, calling for fiscal restraint. Larry Summers and ex- NY Fed President, Bill Dudley are in this camp; though Powell and Yellen are notably on the other side arguing that runaway inflation is not the overriding risk.The heated debate is understandable given the scale of stimulus. Nonetheless, concerns about the inflation genie being let out of the bottle are premature, if not misguided.

For one, record negative output gap reveals severe economic retardation, requiring sustained policy stimulus, not premature restraint. Especially given how uneven the recovery is.  So admittedly, the shape of fiscal stimulus is a justifiable point; but not the need for support. Second, the initial manifestation of reflation – policy stimulus aimed at reviving demand – resulting in commodity/logistics cost-push is a necessary course towards demand revival; in fact, deflationary in the interim due to the erosion of margins/disposable income.

So, rising costs from reflation is not an inflation inconvenience to be (prematurely) snubbed out, but a necessary inconvenience tolerated so that demand may be durably revived. Finally, enhancing quality of jobs/wage recovery along with productivity may also require fiscal capacity building. In other words, this fiscal expansion may be a pre-condition not only for (durable) growth boost but arguably critical to contain future supply-side inflation.

Source: Mizuho Bank Ltd