Is Inflation Making a Comeback? Tentatively, Yes

Is all the money-printing worldwide, not to mention improved economic growth in key regions of the globe, actually helping inflation make a comeback? The tentative answer is “Yes.”

It’s not on fire. It’s not out of control. But it’s there, if you know where to look.

Take Europe, the nexus of the latest deflation scare back in January. We just learned that European inflation rose at a 0.3% rate in May. That eclipsed the 0.2% increase that economists were expecting, and was the first positive reading since the end of 2014. Moreover, core inflation jumped 0.9%. That was the biggest rise in nine months.

European bond markets are taking notice. The huge gains from early in the year … the ones that pushed yields into negative territory after European Central Bank President Mario Draghi launched Euro-QE … have completely evaporated.

Bloomberg’s sovereign bond index is now in negative territory, after being up almost 5% in April. Germany’s bonds just plunged the most in any day since 2012, as inflation concerns begin to take hold.

Here in the U.S., you can see a nascent rebound in inflation worries in the bond market. This first chart shows the difference, or spread, between yields on 10-year nominal Treasuries and 10-year Treasury Inflation Protected Securities (in the lower panel). The wider the spread, the more inflation concern is simmering in the markets.

You can see that this spread sank to a five-year low at the start of 2015. But it has since rebounded to around 184 basis points (1.84 percentage points). That’s a sign the deflation freak out is fading.

Click image for larger view

My second chart shows a different spread – the difference between yields on 5-year U.S. Treasuries and 30-year U.S. Treasuries. This spread tends to collapse when the economy is at risk of slowing, monetary policy is getting tighter, and deflation fears are running rampant. It tends to widen out when the opposite is occurring.

Sure enough, you can see in the lower panel that it topped out at the end of 2013, and declined for several months thereafter. But you can also see the spread bottomed out at a multi-year low of 102 basis points in January … and has since widened to around 140. That’s still well off of the highs, but the story is the same: Nascent inflation pressures are building.

Click image for larger view

Will this trend continue? Or is it just a flash in the pan? That’s the $100,000 question. A lot will depend on what kind of data we get in the coming weeks, what happens in Europe, where crude oil goes, and more. But while we all wait for more definitive answers, you don’t need to wait when it comes to making some portfolio tweaks.

Consider: Long-term government bonds are among the riskiest securities on the planet if inflation picks up. Long-term European bonds also face the risk of credit blow ups tied to the Greek debt negotiations.

Any selloff would also spill over into U.S. debt markets, given our global financial market links. And let’s face it, with yields on a couple trillion dollars worth of global bonds recently in negative territory, you basically have no cushion of safety built in. They’re as overvalued as can be.

So if you own long-term bonds, get rid of ’em. Stick with bond ETFs or funds that have much shorter maturities, or that offer some inflation protection. Then shift some of your funds to sectors that do offer a better margin of safety, because they’ve already been beaten to a pulp. That would include things like energy and other resources stocks.

Until next time,

Mike