Hello, this is Peter Schaffrik, and welcome to our February, 2021 edition of European markets.
Today, I'd like to talk about inflation. Or more precisely, about inflation expectations and how they shape markets. Recently, inflation numbers, when they were released, surprised to the upside, and this was quickly dismissed as just changes in their administrative process. Or in plain English, the reinstatement of the regular German VAT numbers after the emergency cuts last year, or indeed on the special circumstances where the post-Christmas January sales just didn't take place, and therefore on a year on year comparison, prices were higher than they otherwise would be. But we think it would be myopic just to blame it on these factors, important as they are.
The chart that you're currently looking at shows sub indices of the purchasing managers surveys. In this case for prices, input, and output prices. In both Euro area and the UK. As you can see, those indices have been risen sharply and have long surpassed their pre pandemic levels. And the same is true, not only in Europe, but also in other jurisdictions. If you look at the prices paid component in the US ISM index, you can see a very similar pattern. So what is going on?
The next chart that you're looking at shows one example of what we think is going on. It shows freight prices of goods coming into Europe. And, as you can see particularly the freight prices coming out of Asia have increased sharply. This is one example of supply shortages in this case container deliveries. When you look through the ISM report, when you look through the PMI reports, in the common sanction they are littered with examples of supply shortages. In short, what we think is going on is we have a supply shortage on many fronts. This is very different, even though also inflationary from your regular inflationary dynamics, where you typically have a strong performing economy that leads to unemployment, leads to rising wages, leads to higher CPI prices. This is important to remember. So how deal markets with it? On first blush, not at all.
The next two charts that you're looking at shows two year government yields in both the US on the left, and Germany on the right. And what you see in the gray line, they haven't really moved at all. But what you also see is a breakdown in the inflation component and real yields. And here a great deal has happened indeed. Inflation expectations have moved sharply higher. In case of the US now, surpassing levels last seen in the 2017/18 rate hike cycle. And also in Europe, they have increased. And in the meantime, real yields have fallen to new all-time lows, almost on a daily basis. So clearly this implies that despite increases in inflation, central banks are not moving their rates, or in fact, allowing in real space, monetary policy to become even more accommodative going forward. Why is that? Is that because it's temporary? Or is that because central banks have changed their reaction function? Here, we think it's instructive to look at longer tenants as well.
The next two charts show you a very similar picture for 10 year yields in the US on the left, and Germany on the right, with the same breakdown. As you can see, nominal yields, yes, they have moved higher but real yields have hardly moved at all. So even on a 10 year horizon, real yields are not expected to move higher. And inflation expectations are rising sharply as well. In case of the US now, surely surpassing the Fed's numerical 2% goal.
What does that mean going forward? We can see three main scenarios. The first one, is where the market is just plain wrong. Where the inflation increases that we're currently seeing are temporary indeed. And once the economy comes on stream, again those supply shortages are ironed out. The second scenario, is different. The second scenario is one where once the economy reopens, demand induced upward pressure on prices adds to the supply constraint pressures already in place. Yet central banks will be at pains to convince markets that they're not going against the grain. Yes, they will taper their QE purchases, slowly. But they will convince markets with strong wording that rates are not going to move anytime soon. The third scenario is very similar to the second one. The third scenario is very similar to the second one. Once the economy reopens demand pressures will add to supply constraints as well, but central banks will react very differently. They will taper the QE purchases swiftly, and will allow a debate in the market about when rates are going to be hiked to happen. We are strong proponents of the second scenario. We do think that once the economy reopens, central banks will go to length to defend their relatively benign outlooks. They will also go to lengths to convince markets that they will not go against the grain of the market. In case of the ECB, that means a changed mandate. Also akin to the, to the Feds, towards an average inflation goal is likely going to be forthcoming. As a response, we think it's quite likely that we can move the same. We have been recommending short possessions de facto through steepness and the Euro market. We also have been expecting why the inflation expectations and keep recommending those, particularly in the 30 year area of the curve. In this environment, we also think that the UK market is probably going to trade closer to treasuries again than to bonds, and have been recommending spread wideness of the UK versus bonds.
With that, I thank you for watching, and I hope you join me again for the March edition.
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