The virus is skyrocketing and yields are dropping; is inflation already yesterday’s news?

The last time there was so much panic in the markets over higher inflation was probably in the 1970s, when oil shocks were a common occurrence. While inflation isn’t as likely to hit double digits this time around, major central banks have for the first time in decades been faced with the prospect of missing their top price targets by a substantial margin. However, all the excitement may still turn out to have been for nothing as the global recovery is suddenly threatened by a new strain of Covid and optimism for a full economic reopening weakens..

Inflation, an unintended consequence?

One of the unintended consequences of lockdowns during the pandemic has been the severity of disruptions to production and supply chains, which have led to global shortages of key components, bottlenecks and pushed up raw materials prices. raw. Add to that the pent-up demand that has been unleashed with the reopening of economies, and it’s no wonder the prices of the goods and services most affected by the closures are skyrocketing.

Central banks, including the Federal Reserve, insist that these effects will be transient and that once the supply-side issues are resolved and the upturn in demand from the reopening wears off, l inflation will fall. But the big question for markets has always been how quickly these supply disruptions will subside, and with the added threat of wage inflation, investors are more concerned that these price increases will become “sticky.” as policy makers.

Another day, another fear of the virus

However, the inflation jitters seem to have faded of late as fears that the rapid spread of the Delta variant around the world could derail the full reopening of major economies are now seen as a bigger headwind. Investors have been flocking to safe havens regularly since June, but that trend has accelerated this week as the Delta outbreak shows no signs of abating.

After crossing Asia for the first time, this new, more dangerous strain is now spreading across Europe and infections are on the rise in the United States as well. Some traders are already predicting closures will become necessary again by September and the narrative that vaccines will end the pandemic is starting to crumble.

All of this sparked a reversal of the reflation trade that had boosted riskier assets while hammering sovereign bonds. But bonds are now rallying at their strongest since the peak of the viral crisis and Treasury yields are falling; the US 10-year rate fell to a 5-month low, falling below 1.20%.

Falling yields signal ominous clouds are gathering

Falling yields indicate investors are more wary of the outlook, lowering their earlier optimistic growth expectations as the latest escalation of the virus looks set to hamper recovery in a growing list of countries. Safe-haven currencies such as the Japanese yen and Swiss franc are also benefiting from a recovery thanks to risk-free trading. But the most impressive rally was that of the US dollar, which surged even as US nominal and real yields plunged.

The dollar index broke above the 93.0 level for the first time since early April and its 50 and 200 day moving averages look set for a bullish cross. If the bullish momentum continues, the index could soon surpass the March 31 peak at 93.437 and head towards the 123.6% Fibonacci extension of the March-May downtrend at 94.358.

When it comes to major dollar crosses, the $ 1.17 handle is at risk for the euro, the $ 1.3530 Fibonacci level for the pound, and the $ 0.7230 Fibonacci mark for the dollar. Australian, if the greenback continues to attract safe haven flows.

The worst could be over for the euro, not so much for the pound sterling and the aussie

Interestingly, after already being hit hard in June by divergent monetary policy stances between the Eurozone and America, the euro’s decline could be more moderate than that of the British Pound and the Aussie if the latest wave of virus is not receding quickly.

Indeed, investors had placed more hawkish bets for the Bank of England and Reserve Bank of Australia than for the European Central Bank, which was on a more accommodating path even before the Delta variant unleashed itself in the whole world. How the UK, in particular, is coping with the new spike in infections will be watched by the rest of the world.

A dangerous experience

Britain has lifted almost all restrictions despite skyrocketing daily virus cases to the highest since January, with the government banking on the country’s high vaccination rate to keep hospitalizations and deaths low. However, scientists accused the government of a “dangerous and unethical experiment” because letting the virus run rampant could create the perfect breeding ground for vaccine-resistant mutations.

But other than that, the uncontrollable spread of the Delta strain has already started to put pressure on hospitals, suggesting that even with vaccines, some degree of social distancing is needed. If in the coming weeks the UK government is forced to renege on its ‘Freedom Day’ promise, this could be a sell signal not only for sterling but for risky assets in general such as stocks. because that would be a warning to other countries too.

Will blockages force RBA to turn around?

In Australia, the situation is somewhat different as the nation had until recently been able to avoid prolonged lockdowns. But the highly contagious Delta variant emerged at a time when Australia was just beginning to roll out its vaccine. The longer it takes for the final locks to be lifted, the more likely it is that the RBA will maintain its quantitative easing program longer and perhaps even reverse the recently announced cut in bond purchases. It could be a disaster for the Aussie.

To hit or not, the dollar is safe

However, for the greenback, more negative headlines on viruses would likely strengthen it further, even if the Fed’s plan to start reduction talks in the summer is also rejected, as its safe-haven status should protect it. The biggest downside risk to the dollar right now is that infection rates in Europe and Asia are starting to slow, allaying fears about the growth outlook, and markets can breathe a sigh of relief. Then the focus would turn back to US inflation and how soon and at what level it will peak.

The return of stagflation?

But what if the Delta epidemic worsens in the coming months and the global economic rebound is significantly slowed down? Demand would be suppressed again and the inflation problem might go away, but only temporarily. The problem is, more blockages could make long-term supply chain problems even worse. This can then create the ideal conditions for stagflation as governments reach the limits of their fiscal strings and economic growth is unable to rebound so strongly.

Such a scenario would pose an even bigger headache for central banks than the current balancing act of supporting the recovery without fueling inflation. But for the Fed, it will likely continue the debate on reducing its asset purchases, and the uncertainty as a possible signaling of a decision at the Jackson Hole summit in late August looms could itself help. the volatility of the bond. markets.

Either way, the next few weeks will be crucial on three fronts: first, whether the Fed will go ahead and gradually decline and how much will it gradually do so, and second, whether inflationary pressures will show any signs. decrease, and finally, if the number of viruses will increase continues to climb at an alarming rate.

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