Analysts predict a pickup in US inflation, and it could awaken the bond market

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With all eyes on the US CPI prints on Friday night, US inflation data once again came up short.

Annual inflation for July came in at 1.7%, slightly below forecast growth of 1.8% and beneath the US Federal Reserve’s target range of 2-3%.

It’s been a key talking point so far this year, with US inflation steadily declining from a high of 2.7% in February.

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Despite the decline, multiple analysts still expect US inflation to pick up in the first half of 2018.

The ripple effect has flowed through to multiple asset classes, starting with lower bond yields.

Poor inflation data has combined with political gridlock in Washington to create a subdued outlook for interest rates, as the Trump administration’s pledge to legislate for pro-growth tax and infrastructure reforms hasn’t yet eventuated.

Indeed, the yield on benchmark US 10-year treasuries rose from 1.8% to 2.6% in the wake of the US election. But Friday’s inflation data (combined with increasing tension between the US and North Korea) drove yields below 2.2% for the first time since June.

Subdued growth has also contributed to broad weakness in the US dollar. On the flip side, lower rates and a more competitive currency have helped drive US stocks to new record highs.

While US inflation may remain soft throughout 2017, John Higgins from Capital Economics doesn’t believe that will last.

“We expect inflation to rebound in early 2018 for several reasons – this year’s depreciation of the dollar; a faster rise in wages as the labour market tightens; and the fading influence of transitory factors,” Higgins said.

Following the latest CPI print, the CME Group’s Fedwatch tool is assigning just a 36.8% probability of another rate increase in 2017.

Higgins isn’t too phased though. He argues that the US Fed will go ahead and raise rates again this year despite recent data suggesting otherwise.

Westpac chief economist Bill Evans agrees, noting that the US Federal Reserve is aware of the lag between a tightening labour market and higher wages (higher wages are typically a key driver of more inflation growth).

“In our opinion markets are overreacting to the inertia in core inflation and negativity around Trump,” Evans said.

Evans also said that data from the Chicago Federal Reserve shows that US financial conditions aren’t overly stretched right now.

According to Evans, that provides an opportunity (which markets are overlooking) for the US Fed to continue on its path towards normalised interest rates without causing an economic shock.

On the balance of it, “we are surprised that markets are only attributing a 40% chance of a December rate move”, Evans said.

Both analysts said that the US Fed will hike rates in December, and again in 2018 at a more accelerated pace than what the market is currently pricing in.

“If so, bonds in particular are likely to come under pressure in 2018, if not before,” Higgins said.

It will be worth monitoring, given the capacity for changes in bond yields to influence both currency and equity markets.

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