Ready for the summer?

Last week US inflation for April came out as a shock, with both headline and core indices surprising to the upside. What we had been bracing for is materializing: consumer prices are moving significantly up but distinguishing the signal from the noise is going to be extremely difficult for several months (at least). Indeed, much of the acceleration in core inflation could be traced to a few components standing for less than 5% of the index. Yes, bottlenecks are pushing prices up – and by a lot – in sectors such as motor vehicles, but these supply issues (e.g., the global shortage in microchips) do not reflect endogenous overheating (at least not yet). Wages surprised to the upside as well, but there again, the signal is polluted by statistical artefacts.

The picture is too blurry to sway the Fed away from its dovish message. The surge in inflation needs to be put in perspective: the “price gap”, i.e., the difference between the actual price level and where it should be if inflation had been in line with the Fed target, is large after almost 10 years of sub-par inflation. Maybe the ongoing pick-up is precisely what is needed to finally “re-set” long-term inflation expectations to a pace consistent with the Fed’s target. The risk of course is that this goes too far. The Fed is going to be under a lot of pressure this summer as the price hump is likely to continue. Yields should go up in this environment.

The Euro area’s accumulated “price gap” is much wider than in the US, which supports those at the ECB Council now pushing for explicitly tolerating some overshooting in the future. But that issue is unlikely to be addressed before the central bank completes its strategy review. The immediate question to solve is how to mitigate any additional contagion from the US to the European bond market in the months ahead. The acceleration in the pace of the PEPP has not been conclusive so far. We note that at least one prominent sell-side house is now expecting the ECB to reduce its pace of buying at the June meeting. This would be risky in our view. It would run against the needed decoupling with the US and could push the euro higher. Some members of the Governing Council are ready to accept some tightening in financial conditions as a reflection of an improved macro outlook. Unfortunately, even if progress on vaccination is undeniable, the pandemic front remains uncertain, with countries such as Japan and Singapore extending their restriction measures, and the British Prime Minister mentioning the possibility to revise the country’s reopening timeline because of the “Indian variant”. The summer could be “interesting “on the markets.