December 2016 marked the return of 2% headline inflation in the U.S. for the first time since July of 2014. What might seem like an unceremonious milestone is actually a symbolic coda to one of the most tumultuous periods in recent history; an end to the so-called “global deflation trade”. The twenty-nine consecutive months that U.S. Headline CPI spent below 2%, and at times below zero, embodied the thrust of global macro markets over that time period. A period in which the world witnessed a historic decline in commodity prices, a rapid tightening of financial conditions, a collapse of inflation expectations, nominal yields and term premium as well as broad skepticism of monetary policy. While much of the developed world still suffers from “lowflation”, the stabilization of commodity prices and headline inflation has been cathartic for global markets and central banks. The removal of this deflationary “left tail” risk has assisted in re-pricing nominal yields higher and steeper and provided a window for central banks looking to finally reduce crisis-era monetary stimulus.
With more time to reflect on the aftermath of the 2014-2016 collapse of commodity prices and the subsequent “deflation trade”, it becomes clearer just how destructive the ~76% decline in crude oil prices was. Conventional wisdom would have suggested that the historic oil price drop should’ve resulted in a large “tax cut” for American consumers, causing growth to accelerate. On the contrary, the result was actually a nasty feedback loop of lower inflation expectations, higher real yields, tighter financial conditions, lower nominal yields, flatter curves, slower economic growth and narrowing profit margins. For a highly indebted global economy struggling to emerge from the financial crisis, and particularly for developed market central banks hoping to achieve price stability, the sudden hit to the global price level was hugely detrimental. Likely amplifying the negative effects was the U.S. Federal Reserve (Fed), which was intent on normalizing policy, which caused dollar strength and a period of global deleveraging.
This feedback loop manifested itself through a number of channels, but most importantly for global bond markets, the deflation trade caused developed market terminal policy rates to decline as a result of sharply lower inflation expectations, trapping central banks at the zero lower bound despite historically easy monetary policy. The heightened correlation between crude oil prices and 5y5y nominal yields highlights this dynamic. Despite a relatively loose historic relationship, the co-movement spiked during 2014 and 2015. The implication of this sensitivity of expected policy rates to energy prices is that the fall in crude oil prices was not perceived by the market to be a stimulant for developed market economies as one might expect, but rather a depressant of future growth and inflation expectations. With growing debt loads, anemic real growth, tepid core inflation and central banks still trapped at the zero lower bound, the deflationary energy shock was priced by the market as a significant tightening of financial conditions, as short-dated real yields rose sharply, putting the brakes on economic activity. From June to December of 2014, U.S. two-year real yields sold off 166 basis points, which other than the global financial crisis, is the largest increase over a six month period since 2005. The magnitude of this sell-off and the fall in longer-term nominal treasury yields that occurred at the same time encapsulates why the Fed’s nascent normalization process was put on hold.
With steadily rising energy prices has come a sharp increase in year-on-year rates of headline inflation, which have converged with core inflation for the first time since 2014, signaling that the deflationary shock has run its course. What seems like a fairly well telegraphed and simplistic process has actually been hugely important. The normalization of headline inflation has been a blessing for the Fed (and other developed market central banks), as the drop in deflation probabilities and rise in inflation expectations has allowed it to continue its normalization process and convinced the market to start pricing-in a more typical looking hiking cycle via steeper yield curves. Taking a step back and putting aside what the correct monetary policy reaction function is, it actually looks somewhat abnormal that the Fed Funds Effective Rate is only 62.5 bps with headline inflation above 2% and rising, a 4.7% unemployment rate and financial conditions that are loose and loosening. The prospect of fiscal stimulus later in 2017 or 2018 only makes this backdrop look more out-of-balance. The Fed is communicating their intent to follow a “gradual” normalization process, which has been informed in large part by their miss on the inflation mandate. With more typical levels of headline and core inflation, it will be interesting to see how sustainable this stance is.