The U.S. presidential election opened up the flood gates of hope for renewed growth and inflation. Suddenly, markets shifted gears dramatically and bets were placed that 2017 will see the return of higher growth and inflation.The crowded trade became long equities and short bonds on the expectation that the U.S. economy will finally meet and exceed the elusive 2 per cent inflation. As a colleague of mine often tells his clients that they should not adopt ‘hope as financial strategy’. Investors need to have convincing reasons to bet on inflation, not just a hope that the tide is turning.

Let us examine the nature of this “hope “as expressed by the consensus forecast of inflation in the industrialized world (Chart 1). Inflation in the Euro zone is anticipated to jump dramatically from 0.3 per cent to 1.4 per cent by the end of 2017. U.S. inflation is expected to move up smartly from 1.3 per cent to 2.3 per cent. The U.K. will see an even more dramatic move, reaching 2.6 per cent. The United States and the United Kingdom are expected to exceed the inflation targets set out by their respective central banks, thus forcing those banks to adopt tighter monetary conditions. These forecasts call for an acceleration in the general price level that has not be experienced in more than a decade, and certainly have not been experienced within a 12 month period.

Chart 1 Inflation Forecasts

The interest rate markets have adopted this expectation of price acceleration. The 10 yr TIPS breakeven point has surged to over 200bps. The 5yr/5yr rate forecast has move up by 60 bps since the low of this past summer. It seems as if the stage is now set for an outbreak of inflation which has been duly recorded by the near 70bps back up in the 10-yr bond yield. But is this a realistic expectation?

It is hard to believe there is a lot of inflation in the workings of the developed economies. So many of the disinflationary forces over the last decade or so continue to hold considerable sway, such as:

• The aging of the labour force and the general decline in labour market participation rates;
• Excessive savings rates ( low rates of consumption ) in the emerging markets; excess funds will continue to keep long term rates down at current levels;
• Excess capacity existing in most industries;
• Globalization will continue, despite the outcry from certain segments of the population most affected;
• Oil prices will continue to suffer from excess supply, regardless of  the cutbacks proposed by OPEC;
• The rise in the US dollar will keep import prices well in check; and
• The relentless productivity improvements in the manufacturing industries^[1]  will restrain price increases.

None of these conditions is about to reverse itself in 2017 or even in 2018 in such a way as to spur the hoped for inflation.  In addition, any immediate increase in tariffs, as promised by Trump, will result in a temporary spike in prices; eventually, the higher costs for many consumer prices will be deflationary, no different than a consumption tax .The recent Japanese experience of a higher sales tax bears that out. Finally, the easing of regulations in a variety of primary producing industries will reduce costs and final prices.

Nowhere is the issue of expected inflation more apparent   than in the forecasts for 10-yr UST bond.^[2] Chart 2 prepared by Citi demonstrates the perils of forecasting the 10 yr rate. In particular, the reader should take note of the wide dispersion. Within in one standard deviation of the current rate of 2.5 per cent, the range is 1.7 per cent to 3.5 per cent- a quite remarkable range for any bond, posing a real challenge to investors. More importantly, the upper reaches of the distribution depend on very strong economic growth and greater inflation. As for the lower boundary, bond yields will fall dramatically in response to weak growth and moderate inflation. Even the most optimistic forecast for inflation calls for GDP growth will not exceed 2.5 per cent, hardly a result that would generate acceleration in inflation.

Chart2Citi Forecast of 10 yr UST

Source:WSJ, Daily Shot, January 2,2017

Viewed differently, there is a 95 per cent probability that the 10 yr rate will be in the range of 1.7 to 3.5 per cent. For investors this represents considerable risk in placing one’s bets. In other words, the Citi’s 10 yr yield forecast points to massive uncertainty about the outlook. The uncertainty is centred on the expected inflation.For inflation to accelerate sharply, global growth will have to take off, wages will have to rise sharply and the central banks will have to take a much tougher stance on interest rates- the right hand side of the distribution curve. Alternatively, should global growth remain subdued s and national productivity continues to languish and if there is political discord that results in a failure to pass tax reforms and expansionary budgets, then the 10 yr will fall dramatically- the left-hand of the curve.

 From today’s vantage point, the prospects of inflation accelerating are less likely than the consensus forecast. So much has to fall perfectly into place with respect to the political situation. Even more has to fall perfectly into place regarding economic growth. Neither set of conditions is assured.

^[1] U.S. Manufacturing Jobs And Trade Under The Microscope

^[2] The Perils Of Forecasting Interest Rates Edit