Inflation remains one of the few areas where there is not an overwhelming market consensus. We see rising inflation risks

The market is running out of non-consensus narratives, now that we can see the vaccine being rolled out and the potential for a strong economic rebound, and the Democrats managing to win both houses in the US elections and with it the increased probability of more fiscal stimulus.

Yet one area where some disagreement remains is inflation. Consensus economist forecasts sees below target US inflation in 2021 with PCE projected at just 1.7%.

Charts Source: Bloomberg, Macrobond and Variant Perception

This is in line with the Fed’s latest economic projections released in December 2020.

Charts Source: Federal Reserve and Variant Perception

We wrote back in October that higher yields should not derail the recovery trade as long as the rise continues to be driven by the “good” mix of rising real yields and rising inflation breakevens. Since mid November, however, the rise in nominal yields has been driven almost entirely by inflation breakevens.

Charts Source: Bloomberg, Macrobond and Variant Perception

Before, the market saw a mix of growth and inflation, but now it is anticipating a rise in inflation with less growth. This is one potential risk for equities if yields continue to rise in this fashion.

We note that the prospect of greater fiscal stimulus looks to be driving nominal yields higher, even as the US’s current virus situation deteriorates (our Recovery Score in the chart below uses virus and mobility data to gauge which countries are poised to recover from the downturn most quickly).

Charts Source: Bloomberg, Macrobond and Variant Perception

The momentum of yield moves plus fundamentals suggests yields could move higher before the Fed tries to intervene directly or verbally with allusion to yield curve control or an increase to the weighted-average maturity of Fed purchases.

That inflation is a growing risk can be seen from a number of angles, from surveys, to leading signs of a cyclical upturn, for instance the rise in heavy truck sales in the US.

Charts Source: Bloomberg, Macrobond and Variant Perception

The continued rotation into cyclicals also points to higher headline inflation in the coming months.

Charts Source: Bloomberg, Macrobond and Variant Perception

Rising inflation risks and the signs of overbullishness increase the need for portfolios to build in long-inflation exposures or add risk-off hedges.