From the very beginning – that is, from the time Trump was elected – there’s been this creeping suspicion that the new President’s policy platform could dead end in stagflation.
To be sure, this probably never occurred to Trump. He speaks in amorphous platitudes and superlatives. “Big league.” “Tremendous people.” “Good things.” “Phenomenal plans.” “The best deals.” “Great again.”
For Trump, the idea that piling fiscal stimulus atop an overheating economy is likely to create an unfavorable growth-inflation outcome is unthinkable. And I don’t mean in the sense that the new President finds that proposition unrealistic. I mean it in the sense that he hasn’t thought about it. So, literally “unthinkable.”
As I’ve shown on a number of occasions, stimulus isn’t likely to be very effective at this late stage. Consider, for instance, the following set of charts:
Put simply, this isn’t going to work. At least not as it relates to growth, and at least not if history is any guide.
But what it will likely do is put upward pressure on inflation. If the Fed falls behind the curve thanks to pressure from the administration regarding keeping a lid on dollar strength, well then all the worse.
So that’s the setup for the following excerpts from BofAML, who notes that the market seems to be getting increasingly concerned about stagflation.
In our view, the most interesting and important development in the global financial market so far this year has been the divergence between rising US inflation breakevens and falling US real yields. Rightly or wrongly, investors appear to have become concerned about upside risk to inflation and downside risk to growth.
On the surface, this has been an uneventful year for the US rates market so far. As usual, the surface view is deceiving. The seeming collapse in volatility belies the dramatic changes in the composition and term structure of rates. Since the December FOMC meeting, real yields and inflation breakevens have diverged in remarkable fashion. Year to date, 5y real yields have declined by 16bp while 5y inflation breakevens have risen by 12bp (Chart 1); the 5s-30s real curve is 10bp steeper while the breakeven curve is 10bp flatter.
The effect of the divergence between real yields and inflation breakevens has been felt across financial markets. For example, the USD, which trades with real rather than nominal yields, has declined in tandem with real yields (Chart 2). In contrast, gold, which usually thrives on inflation concerns, has been surging lately.
We have seen price action like this before. Indeed, it was quite common during the QE period (Chart 3). However, QE is neither on the horizon nor on investors’ minds right now. So what is really going on? Under normal circumstances, inflation breakevens are a reflection of investors’ inflation expectations while real yields a proxy for their growth expectations. The divergence between inflation breakevens and real yields seem to suggest that investors have become more concerned about upside risk to inflation but downside risk to growth.