Investors shrug off inflation fears

The U.S. inflation figures for January have been anxiously awaited by investors after wage growth sparked a sharp selloff in equity and treasury markets last week over fears of an overheating economy. 

Wednesday’s data confirmed that inflation in the world’s largest economy is on the rise. Headline inflation hit 2.1%, beating the forecast of 1.9%. More importantly, the core CPI, which excludes volatile components like food and energy, rose 0.35% MoM, the biggest monthly rise since 2005, to stay unchanged for the year at 1.8%.

Higher prices are frequently accompanied by an increase in aggregate demand when the economy is at full employment. Making things more interesting, retail sales contracted 0.3% in January. This should become a complex situation for both investors and monetary policymakers if higher inflation accompanies lower spending.   

So far, I still see three rate hikes in 2018 as the base case scenario and, in my opinion, this had already been baked into equity prices after last week’s selloff. However, the risks are skewed to further monetary tightening and this will be problematic for the still overstretched valuations.

In such an environment, some investors might change their strategy to selling the rallies instead of buying the dips, which wasfollowed throughout last year. This requires a further rally in bond yields, and a significant break of 3% on the 10-year Treasuries will likely drive it.

Yesterday’s reversal was quite surprising. Wall Street equities dipped immediately after the release of the data and the S&P 500 opened 0.5% lower to reverse losses within 30 minutes and ended the day 1.35% higher. A similar reaction was seen in European equities which turned to red, but managed to end the trading session in green.

The heightened expectations for rate increases and higher U.S. bond yields should be bullish for the U.S. dollar, particularly against the Yen.  What we currently see is exactly the opposite. The Yen is sitting at a 15-month high against the dollar and showing no signs of giving up gains. This suggests investors are still nervous and unwilling to continue with the carry trade where they borrow the Yen at low interest rates in order to invest in higher-yielding currencies.

The dollar did not just decline against the Yen –it fell against a basket of currencies with the DXY falling 1.4% from yesterday’s peak. This might be harder to explain when rate differentials widen. Markets seem to be expecting the rate differentials to narrow in the next couple of months, as other central banks begin with the tightening process. However, another spike in U.S. bond yields should start attracting more interest to the greenback.