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Deflationary inflation, Eurizon explains the reason for the downward race in Treasury rates

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Continuation of the global cyclical recovery, together with growing attention on the future reduction of monetary stimuli by Central Banks. This is the reference scenario envisaged in the Eurizon monthly report on investment views, which confirms a low directional exposure approach, with neutral positions on the main risk assets, an underweight to duration for the US and Germany and a relative overweight to the Eurozone stock exchanges.
In this context, Eurizon’s monthly in-depth study is dedicated to “Deflationary inflation“. How is it possible that the sharp jump in US inflation in April and May did not drive long-term government rates up, but was instead followed by a fall?

“Inflation is, in fact, a consumer tax. It is sustainable if, and only if, consumer income grows in line with, or more than, the rise in prices. Otherwise it is a tax, and that’s it, that depresses the purchasing power. This is what is happening in the USA “explains Eurizon, according to which”the jump in consumer prices in April and May was not offset by a corresponding rise in wages, whose variation in real terms is largely negative. In this sense, inflation becomes deflationary, because by cutting purchasing power, it creates the conditions for a drop in consumption and therefore a slowdown in the economy ”.

The Fed’s unexpected move

The main novelty of the last period was the change in pitch by the Federal Reserve which now plans to raise rates in 2023, and no longer in 2024. “The program change was already discounted in futures on Fed Funds and has therefore created little volatility ”, reads the report. “It is no coincidence that the Fed has focused attention on the particular reasons that have pushed prices upwards, all linked to post-vaccination reopening, specifying that such a type of inflation should not be countered with higher rates, whose deflationary effect would be reinforced ”.
Furthermore, continues Eurizon, “the Fed has also focused attention on the transience of the inflation flare-up, whose impact on the income of workers (consumers) will be offset as the bottlenecks linked to reopenings are dissolved and as the recovery of jobs will continue lost during the recession ”.

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What will central banks do?

“In the US, there are still about 8 million workers without employment compared to pre-Covid levels. At the rate of recent months, the unemployed will only be absorbed in autumn 2022 ”. It is a distant date, writes Eurizon, “which still deserves an ultra accommodating attitude, but it is understandable that the Fed wants plan in advance the way to reduce the stimulus, so as to avoid communication short circuits at the last minute. For this reason, in the FOMC of last June 16, the Fed anticipated the timing of the first rate hike to 2023 (no longer 2024) ”.
But before raising rates, the report reads, “Central Banks will have other opportunities to test the resilience of economies by reducing purchases of securities. The Fed will announce its intentions in the fall and it will reduce interventions, in all likelihood, in the first half of 2022, to interrupt them in the second. At that point, if the experiment is successful, the rate hike in the first half of 2023 will be a natural consequence “.
For the ECB, Eurizon concludes, “the calendar must be moved forward by three / six months. The securities purchase plan is expected until March 2022. Then it could continue, perhaps at a reduced pace, for at least another six months. And we would be in autumn 2022. For the rate hike, the ECB is unlikely to want to anticipate the Fed; in this case the central months of 2023 could be those candidates for the first move of Frankfurt (provided that in the meantime everything has gone well in the fight against the pandemic and in the recovery of the economy) ”.

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