Forex Investment and Currency Trading

In the major economies, the steep rise in headline inflation is still largely a food and energy story. As many rightly point out, this was an important factor behind the 1970s’ inflationary episode as well. That said, the other three ingredients of the ‘great inflation’ period—loose monetary environment, severely unmoored inflation expectations and high labour market frictions—are non-existent in most
of the developed world currently. With respect to the former, the tightness in the major credit markets, both in terms of higher funding spreads and lower lending volume will help restrain ‘broad money’. And while rates have fallen in the US and the UK, this policy accommodation can be hardly passed onto the broader economy these days given the fragility of the banking system.

The cyclical deceleration for G7 growth should also alleviate some of the inflationary pressure. Tighter margins on the back of weaker consumer demand and a soft labour market should partly offset some of the pass-through from input to output prices.

At the same time, however, the nature of the spike in commodity prices during the 1970s is fundamentally different from the current one. The former was driven by several ‘one off’ supply shocks, while the current reflects a combination of both demand (strong secular EM demand) and supply (elevated geopolitical risks coupled with structural under-investment) forces that are
acting persistently. That is, prices accelerate as weak supply growth struggles to catch up with rising demand.

If energy and food prices continue to rise on the back of this, the risk still lies towards an extended period of ‘abnormally’ high G7 headline inflation. On this basis, market holds a modest long bias on US and Euroland inflation markets for now, but holds a more neutral stance on UK inflation given the brewing deflationary impact of the housing market turmoil. At the same time it is important to acknowledge that inflation markets have already gone a long way to price this acceleration. At this point, it would seem that the upside to inflation markets, although still there, is relatively moderate.

From a valuation perspective, market model sees UK inflation swaps as ‘expensive’ to the tune of 1.5 standard deviation across the curve, but sees US and most of the Eurozone curve as broadly fairly valued.