THU 13 JAN 2022
The way price responded to news of the highest inflation print since 1982 suggests that recent trading was all about the worst-case outcome. Although the December CPI report was modestly above consensus on both a headline and a core basis, the initial market reaction was more indicative of a dovish print. Put another way, there may have been some short-covering in rates and a correlated rally in rate-sensitive equities. That was probably warranted given the recent rise in yields and the shift in the prevailing bias on monetary policy expectations.
As we have also noted recently, headline (and goods) inflation is probably near a peak in year over year terms (chart 1). However, persistent underlying inflation from wages and shelter suggests that inflation will likely remain challenging for the Fed and markets. The sticker shock of the 7% headline inflation print also suggests that it is now a political issue for the Fed, given their current policy stance. It also might have motivated some of the very hawkish comments on active balance sheet reduction by some Fed officials overnight. Of course, talk is cheap and the equity market still appears to be trading as though they won’t follow-through.
The odds of a March hike and faster run-off or active reduction in the Fed’s balance sheet appear extremely high. Moreover, as we noted earlier this week, if the Fed needs to tighten financial conditions, they will need to hike by more than what is currently priced into the fixed income markets. That suggests that there has been a cyclical regime shift from super-abundant liquidity and zero rates to the opposite. While higher rates only tend to problematic for equities later in the cycle, our sense is that the environment will remain challenging for highly levered and expensive entities.
The other correlated price action was in currency markets. The reversal of recent dollar strength was also likely a reflection of position unwind after the worst-case outcome. In turn that likely contributed the relief rally in emerging market equities which tend to trade inversely to the dollar. Dollar strength in 2021 was counter to the prevailing bias at the end of 2020 when most investors were extrapolating trend weakness. Recall that a global recovery is generally associated with US dollar weakness and expansion in dollar liquidity. Of course, reversal in dollar weakness in 2021 was also likely a function of stronger cyclical conditions in the United States relative to tighter credit and liquidity conditions in China and emerging markets more broadly. Notwithstanding the potential for faster-than-expected policy normalisation in the United States, China pivoted to easier credit conditions in December.
The final point to note is that some long term perspective is important on what a US dollar reaction function when the Fed actually does something about inflation. Note the period from 1980-1985 prior to the Plaza Accord in the time series below (chart 3). For now, the US dollar and (most) parts of the equity market apart from the most fragile liquidity beneficiaries and hyper expensive growth. Hawk talk without action is cheap. We continue to retain a quality/value bias within our exposure.