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Not A Canary In The Coal Mine

15 February 2018 by

I can’t recall a US Consumer Price Index (CPI) number in recent years that has been more eagerly awaited than yesterday’s (reporting the Jan data). In the run-up to this, the market has shown signs of anxiety that inflation has built up in the system and has the potential to overheat. The result was a significant shift in market positioning ahead of yesterday’s CPI, which eventually came in higher than expectations. The increase in the January number, month-on-month, came in at 0.5%, well ahead of the market’s expectation of 0.3%, while the year-on-year headline increase was a heady 2.1%, again well above market’s expectation of 1.9% (Core CPI rose 1.8%, vs. 1.7% exp).

These higher than expected inflation numbers would be expected to severely impact the market and indeed the initial reaction was a degree of price correction, but this turned out to be a classic knee-jerk reaction and market levels quickly retraced, particularly in credit. In the US, HY credit initial traded down 0.5-0.75pts but closed flat to slightly up on the day, despite the inflationary signal, however the benchmark 10yr UST continued its move higher, breaching 2.90% yield in afterhours trading. The move in rates does reflect market concerns that the Fed are likely to move more aggressively in terms of both scale and timing of its hiking cycle, but strong technical support together with a strong fundamental backdrop continues to support tight credit spreads.

As we’ve recently written, we are concerned that the Fed may consider adopting a target range for inflation of 1.5-2.5% rather than a hard target of 2%, which takes away a degree of forward guidance and certainty for market. This makes us more cautious towards the longer-end of the US yield curve, and has made the short-end more attractive as we go through this period of transition. Likewise in credit, as most sectors have seen sharp widening over the past couple of weeks, we see value in the front-end of selected credits, where we are confident of exploiting the curve steepness as bonds roll-down to their redemption date.

In terms of yesterday’s CPI print, we’re not so sure that this is the canary in the coal mine for credit markets, however we expect inflation could continue to pick up, which could cause bouts of volatility for risk-on credit. There are some transitory effects in January’s CPI, such as a spike higher in apparel costs, that leave us uncertain whether this is the CPI print that marks an inflection point in the persistently benign inflation backdrop that has challenged the Fed for so long. Additionally, and most relevant to our exposures in credit, the underlying data is still quite constructive, so while we are mindful of inflation and manage our rates exposure accordingly, we continue to find short-duration credit an attractive income generator.

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