Market Relieved by Inflation Reading, for Now

Market Relieved by Inflation Reading, for Now

U.S. core Consumer Price Index (CPI) inflation was softer than consensus expectations in April, and the year-over-year rate remained stable at 2.1%. We see a couple of reasons for that, and continue to expect core CPI inflation to accelerate further (to 2.3%–2.4%) before settling back to 2.2% by year-end.

But perhaps the most interesting aspect of Thursday’s report was the market’s knee-jerk reaction to it: Equities and emerging market assets rallied in relief. This may offer further evidence of a shift we’ve observed in risk sentiment on inflation, from fears of too little inflation to concerns about too much.

Behind the numbers

Used-vehicle prices recorded the largest one-month drop since 2009 and were a big contributor to April’s weakness. However, a recent methodology change likely contributed to much of the volatility. Given that the price drop was somewhat larger than industry indicators – including the National Automobile Dealers Association’s April projection – would have predicted, we think some reversal next month is possible.

Inflation in other categories was firmer. It appears that U.S. dollar depreciation is finally boosting retail goods prices, with April’s acceleration in core retail goods (excluding vehicles and medical goods). This is consistent with the historical lags between changes in the dollar and changes to core goods prices. Household furnishings inflation was particularly firm, including for major appliances and laundry equipment (likely reflecting the impact of tariffs), and apparel was back on trend with a 0.3% rise after volatility in the first quarter (likely related to residual seasonality).

Both rents and owners’ equivalent rents remained firm despite still-high inventories of multifamily housing units in some large cities. We continue to expect a largely stable year-over-year rate of 3.3% for shelter inflation in 2018. An increase in rental vacancies will likely mute shelter inflation despite declining housing affordability arising from higher rates and generally tighter labor markets.

Shifting inflation risk sentiment

We believe 2018 may be the year that challenges preconceptions about the equity/inflation correlation, and the market’s reaction to April’s soft inflation readings seems to bear this out.

When inflation and real activity are moving in tandem, we can expect the correlation between equities and nominal bond yields to be positive. But when inflation is rising and real activity is decelerating, equity performance and nominal bond performance may both falter. This is exactly the time when we’d expect inflation-linked bonds to outperform.

These shifting correlations may have profound implications for portfolio construction. We think below-average breakeven valuations on Treasury Inflation-Protected Securities (TIPS), coupled with rising inflation risk from late-cycle fiscal stimulus, geopolitical risks and trade tensions, may argue for the importance of investment portfolio inflation hedges.

For more of PIMCO’s views on the complex drivers of inflation in the U.S. and globally, please visit our inflation page.

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Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.

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All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.