Low Inflation Underpins Credit Markets‏

One of the key trends over the past years has been the end of the super-cycle in commodity prices. It has not had much attention in financial markets but, in our view, it has very important implications for growth, inflation and markets.

First, it means inflation will remain subdued for a long time. The surprising decline in inflation to 0.7% y/y seen in the euro area yesterday was not a one-off but reflects both high unemployment and lower price pressure from the commodity side. In our view, the ECB will soon have to remove commodity prices from the list of upside risks to inflation that it still has in their monthly statement. Maybe this will happen as soon as next week or at the December meeting, where we now look for a rate cut of 25bp (see Flash Comment: ECB expected to cut the refi rate in December, 1 November).

Second, it adds support to global growth. Lower inflation – driven by commodity prices – increases real income and hence purchasing power for global consumers. In the euro area, for example, real wage growth is now rising 0.8%: wage compensation is growing 1.5% and inflation is 0.7%. This is a clear improvement on the decline in real wages of around 1% that took place in 2011 and 2012. It is also a reversal of what we saw in the 2000s, when rising commodity prices pushed up inflation eroding purchasing power and causing a headwind for growth. It also underpins wealth gains for consumers from stocks and house prices, as it keeps monetary policy accommodative for longer. Coupled with less headwind from fiscal policy and pent-up demand it should pave the way for a stronger global recovery in coming years.

Third, a paradigm of low inflation and higher growth is a sweet spot for credit markets. It means the punch bowl will be in place for a longer time, while earnings rise on better growth. It also drives a continued search for yield in credit markets.

Fourth, it raises the risk of new asset bubbles. The sweet spot for risk for a long time also provides a rising risk of asset bubbles. Last time we had the combination of higher growth and low inflation was in the 1990s (remember new economy?) when the dotcom bubble was formed. House prices are already rising strongly in the US and are likely to continue to do so in coming years as the Fed refrains from raising rates. This will be the main challenge for central banks.

How can they avoid bubbles while low inflation and high unemployment warrant low rates for a long time?

Fifth, it means bond yield curves will be steep. Short rates will stay low for long, while we expect longer rates to be pushed higher by stronger growth. This will give steepening pressure on the yield curves.

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