Macro Monitor: The Fed’s dilemma
Jupiter’s Fixed Income Alternatives team discuss the potent mixture of low growth and high inflation, which continues to animate global bond markets.
In a year that’s been full of surprises, the increase in macro volatility is perhaps one of the few consensus outcomes that has come true. The Q1-21 environment of high growth and low inflation has gone, and with it the reflationary environment for macro assets. This was best exemplified by the steeper yield curves, premised on the belief that central banks would remain on hold until the recovery proved durable and growth rates re-rated to a higher trend. What we have seen over the summer is growth turn lower, the services reopening disappoint, and supply constraints boost inflation expectations.
A high inflation, low growth mix hasn’t been seen for decades, leading to frenetic moves in bond front-end bond yields, not long-dated bonds as many had expected. Transitory inflation has become more persistent and now looks unlikely to dip before output gaps close, meaning inflation is likely to remain elevated into 2022. This could leave inflation above central bank targets for an uncomfortably long period of time, and markets and central banks have had to respond. Both are now taking fewer chances, with central bank policy tightening being brought forward to rein in inflation expectations. Markets are pricing in this central bank pivot alongside an increased risk premium as the outlook becomes less certain and the predictable nature of monetary policy seen since the financial crisis comes to an end.
US Treasury Volatility is at its Highest Level since the Pandemic
Source: Macrobond
The extreme volatility witnessed in front end yields demonstrates the immense regime shift that the reorientation of the growth and inflation mix has brought. Yield curves have also aggressively flattened as real rates have moved lower, creating an additional layer of complexity to the shift. The curve move shows how weak the underlying economy is, still wounded from Covid with high consumer savings rates, a lack of corporate confidence and high debt levels. It seems counterintuitive to get lower interest rates from higher inflation, but the source of the inflation (from supply side pressures and not from strong demand) is for the wrong reasons and so markets are rightly seeing problems down the line.
Goods shortages from the reopening surge and struggling supply chains are likely to last well into 2022 as US Port logjams, China’s ‘zero covid’ stance, limited semi-conductor capacity in Asia and global energy shortages coalesce to prolong the backlogs. Recent consumer indicators show the negative impact this has had with real incomes falling and consumer spending being restrained.
Elsewhere, energy and commodity prices are likely to remain high as we head into winter. Renewable sources of energy have been found wanting as droughts and a lack of wind have proven problematic, while storage issues are yet to be resolved. Meanwhile, the lack of ‘old industry’ investment has constrained fossil fuel supply and gas storage during a cold winter. This will feed further into oil prices and energy-intensive commodities as factories are shut down. The impact on consumers and businesses from high commodity and energy prices is a clear negative.
Commodity Prices are Well Above Pre-Covid Levels
Source: Macrobond
Shortages are also apparent in the labour market, which has played a role in recent job data disappointing. Looking at the US specifically; generous unemployment benefits, health concerns and a surge in early retirement have fundamentally altered labour market dynamics from the pre-Covid era. Although some of these factors could abate into 2022, there are clear warnings (e.g. high job openings, high quit rates) for the Federal Reserve that wage pressures could manifest at a relatively high rate of unemployment.
In sum, it seems to us unlikely that ‘transitory‘ inflation drops meaningfully any time soon, and as output gaps close cyclical inflation pressures will emerge. For example, ‘rent and shelter’, a highly cyclical CPI component, is already rising following the uplift in house prices. Services prices will also recover as health concerns subside. For example, restaurants will need to pass on higher wage and food costs. In light of this, transitory inflation is now expected to last for longer and so the front end sell off that began in the emerging markets has spread to New Zealand, the UK, Canada, Australia and Europe. This has occurred as central bankers have stepped back, and markets have forced the agenda. Simply put: the market and central banks alike are less sure that low inflation will return. Interestingly, the US has been the laggard, which has kept the mighty dollar at bay.
Cyclical Inflation is Meeting Transitory Pressures in the US
Source: Macrobond
Through the re-evaluation of inflation and central bank policy, the relationship between inflation expectations and growth has, if anything, inverted. Typically, higher growth leads to higher inflation expectations as the economic recovery matures. In this instance, higher inflation expectations have led to lower growth expectations and real interest rates have declined as a result. Given high debt levels and the economic scarring from Covid, central banks in a perfect world would stand still and allow deleveraging to proceed. However, central banks have inflation targets and so will have to act at some point. Although policy rate expectations have increased, the repricing has not kept pace with rising inflation expectations. Therefore, central banks find themselves in a position where they need to hike policy rates a lot more to actually tighten financial conditions (via higher real yields). This raises the prospect of even more rate volatility and reliance on central bank guidance. To date risky asset prices have enjoyed the move lower in real yields but if the central banks are committed to slowing inflation, then this could change very quickly.
The UK has been at the Vanguard of the New Inflation, Growth Regime
Source: Macrobond
Rushed rate hikes to head off cost-push inflationary pressures is a sub-optimal monetary policy response, as demand is suppressed too early damaging growth via spending and confidence. Higher debt burdens in both the private and public sector would become costlier to manage and restrictive. A more hawkish central bank path could therefore cause a lot of pain via the higher rate and growth channels and any rate hikes would likely be reversed in short order. If the US central bank were to follow its peers and add a strong dollar into the mix, then this would only add to the problems for the market and tighten financial conditions further. This might be the straw that breaks the camel’s back.
As we have stated many times a path to higher interest rates is possible via a weaker US dollar, low real interest rates and a strong growth mix. The current set up falls far short of this, with inflation rising at a time of low growth thanks to supply side problems. This situation effectively stops this process with interest rates having to rise before the cycle has fully developed and growth has matured. This explains why ‘terminal rates’ are not rising with inflation, a dynamic that can only change if growth swings into a higher gear, or inflation pressures calm allowing central banks to hold back from tightening.
The Fed now has to choose between hiking into a weakening economy or remaining easy as inflation rises. An unenviable position as the central bank has to choose between economic price stability and equity price stability. Given the Fed’s mandate is to support the economy and price stability they are in a very difficult position. Higher real interest rates, a stronger dollar and weak growth would be a disaster for risky asset prices at high valuations.
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