When we analyse the recent performance of assets like Government bonds, commodities, foreign exchange and inflation linked bonds, we get a real sense of a deflationary burst gaining a little momentum. We all know that Europe is currently labouring under very low inflation which may reach 5 year lows when the advance September number is released next week. Elsewhere, excluding tax changes, Japanese inflation is just above 1%, Chinese inflation is at 2% and US and UK inflation rates are both below target at 1.7% and 1.5% respectively.
Considering stimulus totalling US$10 trillion of global QE since 2008, interest rates at zero or very low levels and government debt to GDP at record levels, it is truly amazing that inflation is as low as it is. Furthermore, in many countries, inflation rates are now trending down again. Lower energy prices have been a contributing factor but the deflationary forces from demographics and record high debt levels are the real driving force behind the deflationary trend.
Chart 1 shows Draghi's preferred inflation expectation indicator for Europe. As can be seen, inflation expectations are the lowest point in the available data and, incredibly, below the levels seen at the height of the Global Financial Crisis (GFC). This is happening now despite Draghi cutting deposit rates into negative territory and launching QE Lite. If this inflation expectations indicator continues lower, surely it is simply a matter of time before Draghi launches large scale asset purchases.
CHART 1 – EU Inflation Expectations
Chart 2 below shows US CPI inflation and 10 year breakeven inflation rate. Outside of the GFC, breakeven inflation rates declined in 2010, 2011 and 2013 when the Fed stopped expanding its balance sheet or discussed ending QE. Although the decline in recent weeks does not look significant on the chart, we suspect that the Fed will become quite worried if breakeven rates fall much further. Indeed, a more serious decline could easily persuade the FOMC next year that they can delay rate rises for a long time.
CHART 2 – US Breakeven Inflation Rate and CPI Inflation
What are the odds of a serious enough stalling of US growth to cause inflation expectations to fall? If ECB policies fail to gain traction, Abenomics continues to stutter and the Chinese slowdown continues, then the odds may rise quite quickly. Under this scenario, perhaps the simple question for investors will be whether they will remain comfortable with their optimistic earning forecasts given the deflationary backdrop, and if not, will zero interest rates be powerful enough to support higher equity prices.
The chart below shows the S&P 500 and the Fed's balance sheet. We have indicated the periods of recent Fed balance sheet expansion and it is clear that there is a strong belief that QE is good for the equity market. As we all know, the Fed should announce the end of QE next month, and so perhaps the best way to look at this chart is to note how vulnerable the market is during periods when the Fed's balance sheet is not expanding, as indicated by the red circles.
CHART 3 – S&P 500 and the Fed's Balance Sheet
An interesting narrative emerges when looking at the performance of the US 10 year bond yield during different phases of recent Fed policy. Chart 4 tells the story that 10 year yields rise during periods of balance sheet expansion as investors shift away from safe havens to riskier assets. Conversely, as soon as the Fed stops expanding its balance sheet or announces it will do so (Tapering), bond yields decline, presumably because the structural deflationary forces become the dominant driver.
CHART 4 – Fed Balance sheet with 10 Year bond yield
So, as we enter the fourth quarter, we know that the Fed will end QE, and this could lead to lower bond yields and vulnerable equity markets. At the same time, inflation and inflation expectations continue to melt away despite (some would go as far as to say because of) hyperactive central bank policies. These deflationary forces are manifesting themselves not just in the bond markets but also in the commodity and FX markets.
If the deflationary trends reassert themselves in the months ahead and the ECB is too timid in activating full QE, we should expect the Fed to push out any rate rising cycle as equities come under considerable pressure. However, if the world economy can steady itself and the Fed does not tighten policy too quickly, then perhaps the low volatility environment can continue.
The stakes are extremely high. Without QE or strong economic growth, equity markets may be vulnerable to a sizeable correction. Deflationary forces from demographics and excessive debt levels dominate and central bank policies in recent years have only bought a little bit of time that has not been wisely used by politicians.