US: The inflated reflation story - HSBC

Research Team at HSBC, notes that following the US elections, they have experienced a massive sentiment shift towards fixed income and by now most market participants must feel a fatigue when they hear the terms “Trumpflation” and “reflation”.

Key Quotes

“So the key question is whether inflation expectations are already too high and whether the actual inflation lies with the popularity that the reflation story has gained. In terms of positioning of retail money, the big flows appear to already have happened into ETFs where we are at similar levels as in 2013, nevertheless the flows into mutual funds and stickier forms of TIPS allocations have been fairly light. TIPS are a real rate and not an inflation asset and we are concerned that if we have an acceleration in monetary tightening, TIPS holders may find themselves booking losses, despite stable or even higher inflation.”

“In terms of valuations, we think that break-evens look rather rich and we are likely to witness a correction lower, towards 1.7%-1.8%. In beta-adjusted terms, US break-evens are back to the levels of mid 2015 (see Figure 8) and the beta has largely lagged the actual break-even move. In other words: the main reason for the break-even rise is the sell-off in nominals. From a technical perspective, we have faced resistance to break above the psychological 2% limit.  Most of the oil-related news are already in the price following the 30 November OPEC deal.  The problem which we have faced in the past is the actual implementation of output cuts. Therefore we believe that it is more likely for break-evens to drop in the near term, with the shape of the BE curve steepening slightly.”

“…and the risk-neutral density of inflation

The market appears to be overly convinced that inflation volatility will be low in the coming five years with a 60% probability being priced for CPI-U to be on average within the 1% - 3% range. On 9 Dec 2016 there was a 24% probability for CPI to be in the [2.5%-0.5%, 2.5%] range. If the Trump election is indeed a game changer then past history is definitely no guide into the future. And in our view the market is underestimating the possibility of tail risks in inflation. In the same way that rates volatility has been appreciating in the last few weeks, we should experience more expensive inflation volatility.”