Inflation is Falling
For the professional adviser community only
Last year, the title was ‘inflation is falling?’ the question mark was there because the question was, is inflation falling? And now we know the answer to that which is inflation is falling, so it's no longer a question, it's a fact.
If we look at the oil price, this is one of the big features in inflation last year, or, one of the key drivers of inflation has been oil. We know that oil peaked during the year, around the time of the invasion of Ukraine, and oil spiked at $124 a barrel, and what you've seen is that, actually, oil has been falling ever since. Oil now is actually down close to about $75 a barrel and that's obviously good news because that will feed through into lower inflation. So, what's driving that? What's driving that lower price? There's several factors.
What tends to happen is when you get inflation, central banks raise interest rates. The reason they do that is to try and reduce demands. Now simply, if interest rates are 0%, there's no incentive for you to save. If central banks then increase interest rates to 4% or 5%, you now have an incentive to save. If you're saving money, you're not spending it, if you're not spending money in shops, those shops are making less profits, therefore, you get a contraction in economic growth. It's a simple maths equation, and that's what the central banks are trying to do. They're trying to cool inflation, by giving investors an option, and that option is: cash. They also could do that by increasing the cost of financing for companies. So obviously, if interest rates go up, the cost of running your business goes up, therefore, you're likely to make less profits.
The left-hand side of this chart is looking at inflation data in the US and these figures come out every single month. The expectation is that inflation falls to 6.5%, so we had peak inflation in the US at 9.1%, and now, inflation is falling, and obviously, that is good news.
But what a lot of people were concerned about was not necessarily inflation in the US, it was inflation in Europe and the UK, and inflation in Europe in the UK was higher because it was being driven by a slightly different factor.
So, if we speak about the US, firstly, if I was to ask you, who is the biggest producer of oil in the world, you might think it's Saudi Arabia, you might say Russia, you might say Iran. It's actually the US, who are the biggest producer of oil in the world. So, the higher oil and gas prices were less of a concern for the US. They’re a bigger concern for Europe and the UK. Now what we've had is, we've been extremely lucky in that we've had a very mild winter, which has meant less consumption of gas and oil, which has meant the price of gas and oil has fallen and that is now feeding through into lower inflation in Europe, which is on the right-hand side of this chart.
So, you can see that inflation, obviously, being the big concern of last year, is now less of a concern and that's good news, because what that will mean is that central banks don't have to continue to raise interest rates.
Now, this is an interesting chart here. Basically, what it does is it shows you what the market, or, how the market, is thinking about interest rate rises in the US. So, the market is constantly trying to gage what the central bank is going to do with regard to interest rates.
If we look at the very bottom of this chart, what it's showing you, is the probability, or the expectation of rate rises in the US. What was it telling us a day ago, a week ago, and a month ago? The interesting piece is, if you have interest rates at 4.5% in the US, this is saying, what is the probability of 0.25% or 25 basis point interest rate rise in the US? One month ago, the market was saying there's a 40% chance of that. What's happened between now and then is that inflation figures are coming out and those inflation figures are trending lower.
If inflation is coming down, then the central bank doesn't need to tackle inflation by raising interest rates. So, about a month ago, the expectation was that on February 1st the central bank was going to increase interest rates by 0.5%. Now, the market is putting a 77% probability that it will only be a 25 basis points or 0.25% of a percentage rise.
So, that's telling us that the market now believes that inflation is under control because it thinks we're going to get less interest rate rises and the central bank is also saying the same thing. So this is quite good news because inflation was the key reason markets were selling off last year and now, we're getting a bit more clarity on where the central bank will stop raising rates that’s leading into a stabilisation in markets.
This chart here is a little bit busy but what it's showing you here is the VIX. The VIX is a measure of volatility, it's an index that measures volatility. When the VIX is high, it means that volatility is high. When the VIX is low, it means that volatility is low. When volatility is high, it usually means that you have fear in the markets. So what you've seen throughout the course the last year is that the VIX index has been spiking up and down all year so getting to extreme levels, because people are concerned, particularly about the impact of rising interest rates on stock markets.
So what the black line is showing you is the two-year bond yields. It’s two-year treasuries in the US and you can see that at the beginning of the year, two-year bond yields are low, then the central bank increases interest rates and it goes up continually. So, the whole point here is that the central bank started to increase interest rates and then the market says, what will the impact of those interest rates be on company's profits in the future? The answer to that, the market says, is, I don't know, because I don't know how much the central bank is going to raise rates.
So what happens is, you get this VIX or volatility index spikes up. You get a lot of fear and markets, markets are selling off because they don't know where interest rates are going to get to. At the beginning of the year, we had a couple of rate rises and then the market is thinking, trying to second guess the central bank, will the central bank stop raising rates? Because if you raise interest rates, you're going to break something that you're going to create a recession.
Then, you see a stabilisation in that volatility falls and then, the central bank comes back, and they say, look, our fight against inflation is not over, we’re going to have to continue to raise rates so volatility picks back up, equity market sell off.
But the point is, looking at the very dotted black line on the right-hand side, the point is that that that two-year bond yields have now stabilised. Why is that? It's now stabilised because it's telling you, the bond market now believes they have a good understanding of where central bank interest rates get to. Where's the peak? We have visibility on the peak, because inflation has stopped rising, and it's now falling, and we only expect to more rate rises and actually, we expect those to be lower than we initially thought, which is good news, which is why you're getting more optimism or a bit of a rally within equity markets.
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