Grant's Interest Rate Observer.

Inflation Coming?

Inflate gate

Take a bow, central bankers of the world! Evidence of the long-sought after return of measured inflationary pressures is accumulating.  A trio of sovereign sightings in the past 24 hours:

 

Swedish underlying consumer price inflation (which adjusts for fluctuations in mortgage prices) for November logged at 2.0%, above the 1.8% economist consensus and the 1.7% expected by the Swedish central bank, the Riksbank.  Jonas Goltermann, economist at ING Bank NV, wrote that: “The [Riksbank] policy committee will be pleased with the confirmation that inflation is back to target. But we think the dovish majority will want to keep policy accommodative for some time yet to avoid the risk that inflation falls back again.”  The central bankers may be pleased, but someone should wake up Sweden’s sovereign creditors and let them know. The Swedish Government Bond 0 3/4s of May 2028 are trading at 100.72 cents on the krona, for a nominal yield-to-worst of 0.68%. If inflation holds at this level, those notes sport an annual real yield of negative 1.3%.

 

Mark Carney, governor of the Bank of England, has a new homework assignment.  As a result of the 3.1% year-over-year increase in November’s CPI reading (the highest since March 2012), Carney will be compelled to write a letter to the chancellor of the exchequer explaining why inflation has deviated by more than 1% from the central bank’s 2% target.  Food and energy prices rose by 4.0% and 6.8% year-over-year, respectively, but diverse categories such as clothing and footwear (+9.8%), household goods (+4.4%) and autos (+5.5%) demonstrated the relatively broad base of the price pressures.

 

So far, U.K. CPI has averaged 2.4% in the eleven monthly readings of 2017, compared to 0.6% year-over-year through 2016 and zero in 2015.  Lucy O’Carroll, chief economist at Aberdeen Standard, wrote that: “It’s quite possible that inflation is now close to its peak.” For the sake of U.K. creditors’ prospective returns she had better be right.  The 10-year gilt currently sports a 1.22% nominal yield (just a basis point above its simple average for 2017) and a negative 1.9% real yield, based on the November inflation reading.  

 

Stateside, this morning’s release of the producer price index for November showed the same trend: up.  The headline final demand component rose by 3.1% year-over-year and by 2.3% ex-food and energy (the highest and second highest readings in five years, respectively), bringing the average 2017 gain to 2.3% in the headline series with just one month remaining. In contrast, 2016 averaged a 0.4% year over year advance, while 2015 PPI declined by 0.9%.  In this context, at least, investors in U.S. Treasurys are in slightly better shape than those in gilts or Swedish government bonds.  The 10-year note yields a relatively superior 2.40%, while the Federal Reserve is expected to raise overnight interest rates at tomorrow’s meeting (futures price 100% odds). 

 

The July 15, 2016 historical analysis in Grant’s (“Remember the Shell Union Oil 2 1/2s of 1971”) featured a cautionary tale for potential fixed-income accidents that involve no default or corporate distress.  

Shell Union was a substantial and creditworthy borrower. In 1945, it showed net income of $28.7 million, cash and government securities of $118 million and a current ratio of 3:1. From balance sheet details as the press revealed, there appears to have been little net debt.

In the spring of 1946, any clairvoyant could have seen that credit risk was yesterday’s worry, particularly with so solid a citizen as Shell . . . Obviously, interest-rate risk was the coming thing. Only later, and at much higher yields, did this great truth penetrate the mind of the market. 

Is the credit cycle, notorious for its generation-length (or longer) trends, finally turning?  Maybe not, but it sure doesn’t hurt to consider the possibility.