Too High or Too Low?

The U.S. inflation narrative has flipped, which has caused some bond-market angst recently.

Deteriorating global conditions have shifted the economic landscape and fueled concerns that inflationary pressures could be too low, hinting to an impending U.S. economic slowdown. The 10-year Treasury yield slid to a 15-month low in March as bond investors priced weakening inflation into rates, briefly inverting the yield curve (short-term rates moving higher than longer-term rates).

However, we see signs that lower inflation fears could be fleeting. As shown in the LPL Chart of the Day, wage growth remains healthy even as consumer price growth has weakened, showing us that cost pressures are building underneath the surface.

Consumer Prices Bear the Brunt of a Global Slowdown 1

Average hourly earnings climbed 3.2% in March, just below the cycle-high growth of 3.4% reached in February. Over that same period, the core Consumer Price Index (excluding food and energy) rose 2%.

Wage growth is an important inflation indicator to watch, as wages constitute about 70% of business costs. Producer, or wholesale, price growth is also humming along at a steady pace. Overall, companies are incurring higher input costs, but they haven’t raised prices at the same rate.

“Consumer price inflation hasn’t fallen to alarming levels, but the trend reflects the sting of lower global demand,” said LPL Research Chief Investment Strategist John Lynch. “Wages and producer prices have steadily risen over the past few months, and we expect businesses to eventually adjust their prices as demand recovers.”

Bond yields have also reflected brighter global prospects recently. In the first two weeks of April, the 10-year yield posted its biggest increase since October as U.S.-China trade talks progressed and China economic data showed signs of improvement. Any resolution to trade headwinds could help lift demand and support healthy price inflation going forward.

Even though we think inflation will pick up, we still think there are low odds of the U.S. economy overheating at this point. Structural changes in the U.S. economy, increased global competition, and improving productivity should keep a lid on inflationary pressures long term. Overall, we expect slightly higher inflation to lift the 10-year yield to 3 — 3.25% at the end of 2019.

For more of our thoughts on the state of inflation, check out this week’s Weekly Economic Commentary.

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