Market Extra: Inflation has yet to peak in most G-10 countries and ‘we are waiting for a proper market reality check’: BofA


“The inflation genie is still out of the bottle.”

Those are the words of strategists Claudio Piron and Athanasios Vamvakidis at BofA Securities, who said on Friday that inflation has yet to peak in most Group-of-10 countries and that “we are waiting for a proper market reality check.”

In an email to MarketWatch, Vamvakidis, the London-based global head of G10 FX strategy, said the “reality check” refers to “all markets” and the need for “a proper risk-off, as the economy weakens but inflation is high and sticky.” He notes that in most G-10 economies, core inflation, which excludes volatile food and energy prices, has yet to start falling.

For the most part, financial markets have been bifurcated across two lines of thinking — one in which inflation remains stubbornly high because of unexpected economic strength, and the other in which slowing growth and/or approaching recession helps cure the inflation problem by bringing down price pressures. BofA Securities raises a third, less-talked-about scenario in which inflation doesn’t end up easing as much as many expect, even when there’s economic weakness.

“The reality is that we thought inflation was peaking and maybe it hasn’t,” said Rob Daly, director of fixed income at Glenmede Investment Management in Philadelphia, who helps oversee more than $4 billion in institutional fixed-income strategies. “It’s certainly moderating, but it’s the pace of that moderation that matters. The markets have been slow to adjust to the reality of stickiness to inflation. There’s a level of uncertainty that is really capturing the market’s focus and that we have to put our hands around. Nobody knows where it’s going, especially central banks.”

Uncertainty over the most likely path of inflation and course of central-bank action has only increased this week. A steady stream of data out of the euro zone, Spain, France and the U.K. threw cold water on the idea of easing price pressures, while China’s manufacturing rebound looked better than expected. U.S. data is pointing to continued labor-market strength and economic resilience, while traders of derivatives-like instruments known as fixings expect the next major inflation update — the February U.S. consumer-price, released on March 14 — to reflect an annual headline rate of almost 6.1%, versus 6.4% in January.

Yet on Thursday and Friday, financial markets clung to hopes that the Federal Reserve could pause its rate hikes this summer, spurred by comments made by Atlanta Fed President Raphael Bostic, who said he is firmly in the camp that supports quarter-of-a-percentage-point interest rate hikes. Bostic’s remarks helped power a rebound in U.S. stocks DJIA, +1.17%   SPX, +1.61% COMP, +1.97%, which finished higher on Friday; contributed to a pullback in Treasury yields, and prompted traders to somewhat reduce their expectations for a half-of-a-percentage point Fed rate hike on March 22.

With the stock and bond markets fluctuating this week between hopes for a Fed pause in interest rate rises and the higher-for-longer view on rates, the implications of persistent inflation on the around-the-clock currency market are mixed. While the still-hot U.S. labor market supports the dollar, rising euro-zone inflation and a data-dependent European Central Bank “should be positive for the EUR [euro],” Piron, an emerging Asia FI/FX strategist in Singapore, and Vamvakidis wrote in a note on Friday. BofA expects the EUR/USD EURUSD, +0.36% to trade at 1.10 by year-end versus 1.05 in the first quarter.

Although the dollar is now close to their forecasts for the first half, “we do not believe the market had a proper reality check yet,” they said. “We will feel that this is the case only when both bad news and good news are bad news — the former because the Fed will have to keep hiking, the latter because the Fed cannot cut rates for as long as inflation remains high and sticky.”

Meanwhile, a team at Deutsche Bank came out with multiple scenarios for Treasury yields through the end of this year. The team’s baseline scenario is for the policy-sensitive 2-year yield TMUBMUSD02Y, 4.871% to get to 4.65% and the 10-year TMUBMUSD10Y, 3.959% to reach 4.15% during the first quarter. However, they haven’t ruled out some risk that the shorter-term yield could jump to 6.15%, and the 10-year could reach 4.9%, by the end of this month under a “higher for longer scenario,” up from 4.86% and 3.96% respectively on Friday.

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