What is the impact of the latest US inflation data?

As in recent months, a handful of inflation categories experiencing outsized gains have disproportionally affected headline inflation, leading to yet another upside surprise. Used cars alone contributed the bulk of the overall price level increase. Pent-up demand meeting supply bottlenecks pushed consumers willing to splurge on a new car towards second-hand alternatives.

While these effects should begin to fade in coming months as shortages ease, demand normalises and last year’s prices fall out of the calculations, a central bank that lets inflationary pressures go unchecked could be a risk. This is because the combination of monetary and fiscal stimulus – of sustained ‘money printing’ to ‘monetise’ government debt – could at least in principle continue to drive money supply higher and higher.

The second half of the year is likely to see both the Fed and European Central Bank announcing that they’ll scale back their asset purchases – as the Bank of England has been doing for some time. So, while central banks will maintain an accommodative stance and continue to expand their balance sheets, partly as governments’ borrowing needs remain high, they’ll do so at a slower pace.

Of course, if the Delta or other virus variants were to trigger widespread restrictions to mobility, there would be a catalyst to downgrade the growth outlook. But, so far, it’s not obvious that very strong though slightly less buoyant macro conditions are the key driver of the sharp decline in bond yields, especially to such a low level. If the economy normalises, so should policy, to mitigate the risk of financial instability and the need to tighten more aggressively later on – and that’s a good thing. If the inflation spike turns out to be transitory, the Fed won’t need to tighten policy that much. So bond yields won’t have to rise that much either, supporting riskier assets.

US inflation came in way above expectations at 5.4% versus 4.9% expected. Core inflation, which excludes food and energy, rose 4.5% versus 4% expected. The jump in reported inflation is largely attributable to commodity and wholesale price increases and a small number of sectors within the economy most affected by reopening-related bottle necks.

Once these resolve, and the base effects from last year go into reverse, inflation should drift back towards the 2% target… or so says the Fed which continues to reiterate the transitory nature of said inflation. We’ve witnessed this narrative play out across markets, most notably via the dramatic plunge in the 10-year US Treasury yield which fell from 1.70% to 1.25% in just a few weeks. We disagree with that narrative.

Further, markets have a tendency to overshoot, and yields are simply too low to reflect the current economic reality. Today’s numbers validate that view, specifically the month-on-month headline reading, which excludes base effects, up 0.9% versus 0.5% expected. Inflation will remain elevated and prove more stubborn than current consensus expectations. This is not the time to chase yields lower but to re-enter the reflation trade.

As Wednesday saw the England football team entering territory uncharted for the past 55 years, the US stock market was doing the same thing, although on a somewhat less spectacular scale. Wednesday was the ninth day on the trot that the broader S&P 500, an index of the stocks of 500 leading companies in the US economy, hit fresh all-time highs.

Anyone who, at any point in history, had bought an S&P tracker and was still holding it on Thursday would have been sitting on a profit. It is said that bull markets climb a wall of worry - investors balance their glee with potential profits with the fear that a crash may only be just around the corner. Just in case stockholders were getting a bit too complacent this time around, Thursday did deliver a sharp sell-off as the US opened.

Investors have likely had the same nagging worries all year. Is inflation going to end up being more of a problem than central banks think - and will rates have to be raised sooner than expected? Add into the mix the news that Japan has declared a state of emergency and the Tokyo Olympics will be going ahead without any spectators, due to the coronavirus. This may well have rattled some, worried about another resurgence of the pandemic and the corresponding threat on the economic recovery.

But if history is going to repeat itself, it could be that these worries don't look big enough just yet to spook markets and cause a more sustainable sell-off. After a few hours of trading, stocks in the USA were attracting buyers once.

It wasn't just the stock market that saw a burst of volatility. The price of oil moved ever high as the week started, hitting its best levels, albeit very briefly, since late 2014. The breakdown of talks between OPEC and OPEC+ was the reason for the sell-off - and it is a market many consider overdue for a correction given it has risen seven-fold in 15 months. But like with stocks, traders tend to buy the dips expecting further strength. If oil increases further, then surely concerns about inflation are only set to increase.

For now, markets still look to be undeterred - although that can be a dangerous belief to hold onto indefinitely. Just ask a Bitcoin buyer from April."