Albert Edwards, Soc Gen’s London based uber-bear, has released his latest Global Strategy Weekly, which neatly sets out his thesis on why a collapse in inflation expectations by traders in the US and Europe is so important.
Edwards says that the collapse of market expectations via the 5-year inflation expectations, now back below January’s lows means “bond investors are signalling to us that they dont believe the Fed is in control anymore”.
He also said that the “Fed by contrast is brushing aside the market’s deflation concerns,” which to him feels very much like BoJ missteps in the mid-90s, when the yen strengthened.
That’s a view supported by the latest FOMC minutes, released earlier today.
“The staff projected that consumer price inflation would move down over the near term by more than in the previous projection,” the minutes said.
But, in their best panglossian tone, Fed staff then “projected that inflation would rise gradually over the next several years”. They say however that inflation is still likely to be below the 2% Fed target in 2018, which suggests Edwards is onto something.
Bond market estimates of where inflation expectations will be in 5 years time are a somewhat arcane, yet very important indicator of what traders and investors are thinking. But that import is not accessible to many investors, let alone the casual observer or general public, Edwards explains.
Why is the ongoing slump in inflation expectations so significant? Because it represents the dark side of the same coin that most investors choose to ignore focusing instead on the bright, equity side of the coin.For equities, and asset prices generally, the consistent weakness of both the US and global economy since the Global Financial Crisis has meant that monetary policy has stayed super-easy. That has inflated asset prices way beyond their fair value indeed that is the very purpose of QE.
The collapse in inflation expectations tells us that the market believes the central banks, despite their monetary profligacy, are failing to prevent the western economies from turning Japanese, and thus at risk of repeating their devastating slide into outright deflation in the 1990s. And the actual poverty of pricing power (even once food & energy are excluded from CPI measures) in the US and globally means that corporate revenues remain very weak, particularly in the US; consequently the economic cycle remains very fragile indeed.
We have all been warned.