The Great Inflation Debate

Market Reaction: February 9, 2021


Stocks across most regions surged as market volatility fell and expectations of large U.S. fiscal stimulus rose. In the United States, both the S&P 500 jumped 4.7% - its best week since November. The NASDAQ surged 6.0%. Non-U.S. stocks also rose with European shares climbing 2.3% and Japanese shares adding 3.7%. Emerging Markets stocks jumped 5.0%. The 10-year U.S. Treasury yield rose 10 basis points to 1.16%.

Investors are rightfully expecting more stimulus with Citi’s economists looking for a fiscal stimulus bill of $1.5 trillion to be passed in March. These expectations are being reflected in the bond market with the 10-year Treasury yield reaching its highest yield since mid-March 2020.

Inflation expectations have climbed to above 2.0%, but the Fed is unlikely to change its current policy stance anytime soon. However, if inflation continues to tack higher over time, then investors may start to debate whether or not a tapering of Fed policy could occur sooner than currently anticipated.

The Week in Review

Several of the high-flying retail investor stocks lost momentum. After causing high volatility in select corners of the market as the desires of the hedge fund community and retail investors clashed, a number of those trades unwound. This fit with our view that there would likely not be long-lasting consequences for broader equity markets. As our Citi Private Bank colleagues pointed out, the 100 most shorted names in the Russell 3000 index (a benchmark of the entire U.S. stock market) make up just 0.7% of the market-capitalization. This suggests that the risk of broad market contagion likely remains low even if pockets of froth pop up once again.

The ISM manufacturing index fell back from 60.5 in December from a still-strong 58.7 in January. The decline was driven by a normalization in new orders from a historically elevated 67.5 to 61.1 and production from 64.7 to 60.7. Employment, which has lagged activity and orders, increased from 51.7 to 52.6. Prices paid increased to 81.2, the highest reading since 2011. It was the first time since 1978 that no firm reported lower prices. Most forward looking signs continue to point to a U.S. economy that is expanding, not contracting.

The Great Inflation Debate

Unsurprisingly, the unwind of the retail investor feeding frenzy got a lot of attention last week with several of the high-flying short-squeeze names tumbling and the VIX, which is a measure of market volatility, fell back to normal levels. However, away from the retail sideshow, the debate over additional fiscal stimulus and inflation expectations seems to be heating up and driving financial markets.

Before we discuss the prospect of inflation, let’s review the January employment report. The U.S. economy added just 49,000 jobs in January, which was a clear disappointment with the consensus looking for 105,000 jobs to be added. Private payrolls rose by just 6,000. However, the household survey, which is what is used to calculate the unemployment rate, showed an increase of 201,000 jobs. This caused the unemployment rate to fall from 6.7% to 6.3%. Although the employment report was disappointing, other labor market indicators like the ADP report, the ISM survey employment components, and initial jobless claims told a better story in January. While Treasury Secretary Janet Yellen warned that the labor market is stalling and might not recover for years without President Biden’s stimulus package, we think that is a strong case for continued positive payrolls growth moving forward as COVID-19 restrictions get relaxed and we exit the seasonally challenging winter months (see figures 1 and 2).

Figure 1. New Confirmed COVID-19 Cases (7-Day Rolling Average)
Figure 1: ...
This line chart shows the number of confirmed COVID-19 cases in the USA between January 2020 and February 2021. There was a sharp rise in cases from October to the start of January 2021, followed by a steep drop during the month of January.
Sources: Bloomberg and Citi U.S. Wealth Management as of February 8, 2021
Figure 2. Employment in Food Services & Drinking Places (Monthly Change, Thousands)
Figure 2: ...
This bar chart shows the Employment monthly change (in Thousands), in Food Services and Drinking Places between January 2020 and January 2021. Feburary 2020 is up 61, March 2020 is down 632, April 2020 is down 5343, May 2020 is up 1499, June 2020 is up 1478, July 2020 is up 532, August 2020 is up 105, September 2020 is up 239, October 2020 is up 200, November 2020 is down 25, December 2020 is down 402, January 2020 is down 19.
Sources: Haver Analytics and Citi U.S. Wealth Management as of January 2021.

In some ways, the employment report could be viewed as goldilocks for policymakers that are pushing for significant fiscal stimulus with Democrats in both the House and Senate voting last week to use the budget reconciliation process for the next COVID-19 relief bill. Current expectations are that a bill will be voted on before the current tranche of enhanced unemployment benefits expire on March 14th.

House Majority Leader Steny Hoyer said the House plans to vote on the final package the week of February 22nd.  There is still a chance that we will see a bipartisan deal with Republicans, but it is looking like Democrats are willing to push forward on their own. That doesn’t mean it will be easy. The exact details of the stimulus bill still need to be hashed out, including how to restrict the eligibility of the $1,400 direct stimulus checks, and whether or not to raise the minimum wage to $15 by 2025. One side effect of the budget reconciliation process means that Republicans can object to items that they see as non-budgetary in nature, which likely includes the minimum wage hikes. In addition, Democratic Senator Joe Manchin from West Virginia has also said that he will not support the minimum wage hike, which could be a death knell for the measure as every single Democrat’s vote in the Senate is needed for it to pass (assuming there is no Republican support).

Either way, financial markets are rightfully expecting more stimulus with Citi’s economists looking for a bill of $1.5 trillion to be passed in March. As a result, the 10-year Treasury yield jumped 10 basis points to 1.17% last week – its highest yield since mid-March 2020. Inflation expectations, as measured by the 10-year U.S. Treasury breakeven inflation rate, have climbed to above 2.0% (see figures 3 and 4). Though it should be noted that the consumer price index tends to track about 0.40% higher than the Fed’s preferred measure of inflation (the personal consumption expenditure price deflator). In theory, this should mean that the 10-year U.S. Treasury breakeven inflation rate would need to reach about 2.40% before it should be considered consistent with the Fed’s stated goal of 2.0% inflation.

Figure 3. 10-Year U.S. Nominal Treasury Yield (%)
Figure 3: ...
This line chart shows the 10-Year U.S. Nominal Treasury Yield (%) from June 2019 to February 8th 2021.
Sources: Bloomberg and Citi U.S. Wealth Management as of February 8, 2021.
Figure 4. 10-Year U.S. Treasury Breakeven Inflation Rate (%)
Figure 4: ...
This line chart shows the 10-Year US Treasury Breakeven Inflation Rate(%) from June 2019 to February 8th 2021
Sources: Bloomberg and Citi U.S. Wealth Management as of February 8, 2021. Note: The 10-year breakeven inflation rate = (10-year nominal Treasury yield) – 10-year U.S. Treasury Inflation-Protected-Securities yield). It is called the breakeven rate because an investor would receive the same total return on a nominal Treasury bond as an inflation-protected bond if consumer prices average that level over the next 10 years.

It is also worth noting that back in August 2020, the Fed adopted a flexible form of “average inflation targeting” that aims for an inflation rate that averages 2.0% over time and will allow inflation to run moderately above the Fed’s 2.0% goal for some time following periods when it has run below that objective. As such, it seems highly unlikely that the Fed will abruptly change its current policy stance anytime soon (they expect to keep interest rates at zero through at least 2023). However, if Treasury Secretary Janet Yellen is correct in her assessment that the U.S. economy can reach full employment by mid-2022 on the back of the proposed fiscal stimulus package and the Fed’s inflation target has been reached, then it seems reasonable to assume that a rate hike might occur sooner than they currently projecting.

While investors have called for the return of inflation before, those calls have largely went unanswered. This time around may end up being no different, but there are some tentative signs that modest inflation risk may be building with recent manufacturing surveys in both China and the U.S. pointing to higher input costs. Both the Caixin China composite purchasing manager’s index (PMI) output prices component and the U.S. Institute for Supply Management’s (ISM) prices paid index jumped in January. In the case of the ISM, the component jumped to its highest reading since April 2011. Both components lead traditional measures of inflation by about a month and point to an inflation rate that is above 2.0% (see figures 5 and 6). Although it is worth noting that past spikes in these survey data (see the red circles in figures 5 and 6) were not always been matched by forthcoming inflation data.

Figure 5. China Manufacturing Input Prices vs. U.S. Inflation (as Measured by the PCE Deflator)
Figure 5: ...
This line chart shows the Caixin China Composite PMI Input Prices (Left) and PCE Price Deflator (Year on Year %, Right) from 2008 to 2020
Sources: Bloomberg and Citi U.S. Wealth Management as of February 8, 2021.
Figure 6. U.S. Manufacturing Prices Paid vs. U.S. Inflation (as Measured by the PCE Deflator)
Figure 6: ...
This line chart shows the ISM Manufacturing Prices Paid Index (Left) and PCE Price Deflator (Year on Year %, Right) from 2008 to 2022
Sources: Haver Analytics and Citi U.S. Wealth Management as of January 2021.

If indeed the calls for inflation are answered this time, then we would expect 10-year Treasury yields to push modestly higher over time and to see a continued rotation toward small- and mid-cap stocks and the Financials sector. Although an unloved sector, Financials have actually taken the market leadership reins from the Technology sector (considered sensitive to interest rates) over the last six months (see figure 7). Energy, tangible assets, and commodities may also see a bid.

Figure 7. S&P 500 Total Return By Sector (Past Six Months)
Figure 7: ...
This chart shows the total return for the various S&P 500 sectors for the past six months. Data shown indicates Information Technology at 19.6%, Consumer Discretionary at 19.4%, Communication Services at 22.2%, Materials at 20.2%, S&P 500 at 17.8%, Healthcare at 9.4%, Consumer Staples at 5.8%, Industrials at 21.9%, Real Estate at 7.5%, Utilities at 7.8%, Financials at 28.5%, and Energy at 17.0%.
Sources: Bloomberg and Citi U.S. Wealth Management as of February 5, 2021. There can be no assurance that these market conditions will remain in the future. Past performance does not guarantee future results.

U.S. Stock Market Returns and Select Assets
Index Wkly Chg YTD 12 Months Div. Yield
Dow Jones 3.9% 1.8% 6.3% 1.9%
S&P 500 4.6% 3.5% 16.6% 1.5%
NASDAQ 6.0% 7.5% 45.7% 0.7%
Instrument Wkly Chg YTD 12 Months Level
10-Year Treasury Yield (%) 9.7 bps 25 bps 40 bps 1.16%
Gold ($/Oz.) -1.8% -4.4% 16.6% $1,814.1
Oil ($/bbl) 8.9% 17.2% 12.0% $56.85
International Stock Market Returns
Index Wkly Chg YTD 12 Months Div Yield
Global 4.3% 3.8% 16.9% 1.7%
Europe 2.3% 0.8% 4.3% 2.4%
Japan 3.7% 2.6% 17.1% 1.9%
Emerging Markets 5.0% 8.2% 30.9% 1.8%
This table shows changes and returns over various periods for U.S. and international stocks and select assets.
Sources: Bloomberg and Citi Personal Wealth Management as of February 5, 2021. Note 1 (Equities): Global = MSCI All Country World Index (USD); Europe = MSCI Europe (USD); Japan = MSCI Japan (USD); Emerging Markets = MSCI Emerging Markets (USD). The equity index returns shown here are based in U.S. dollars. Returns for a non-U.S.-based investor can differ significantly depending on the effects of foreign currency exchange. Note 2 (Instrument): Gold = U.S. dollars per Troy ounce; Oil = West Texas Intermediate crude at Cushing, OK.

Date Time Event Period Surv(M) Prior
2/9 6:00 NFIB Small Business Optimism Jan 96.8 95.9
2/10 8:30 CPI YoY Jan 1.50% 1.40%
2/10 8:30 CPI Ex Food and Energy YoY Jan 1.50% 1.60%
2/11 8:30 Initial Jobless Claims 2/6/2021 755k 779k
2/12 10:00 U of Mich. Sentiment Feb 80.9 79.0
This table shows survey and forecast results for the given events for January and February 2021 alongside results of each event from the prior period.
Sources: Bloomberg and Citi Personal Wealth Management as of February 6, 2021.