On the Highway to Sell (Encore)
Mon, 13 Dec 2021
The US November CPI data reported on Friday, and the associated market reaction highlights the importance of assessing how price responds to news, rather than purely focusing on the information itself. The inflation print was in-line with consensus, albeit at the highest year on year rate since 1982. However, equity and fixed income markets rallied in price, probably because the data was not materially higher than expectations. Put another way, the market had become accustomed to upside inflation surprises, and for once we did not get one.
The big picture point is that the prevailing bias expects inflation to mean revert and come back down. As we noted last week, the market is also still confident in the Fed’s ability (and willingness) to influence inflation and therefore the Fed’s credibility. While short rate expectations have moved higher for 2022 and 2023, terminal (or neutral) rates remain moderate relative to the FOMC median expectations. In short, more rate hikes now equal less later.
As one of my mentors reminded me last week, you have to work out the nature of your quarrel with price. Our sense is that the US Federal Reserve might be committing a costly policy error based on the false premise that inflation is pending a normalisation through supply side adjustment. In other words, that the current inflation episode has also been driven by excess demand and might be more persistent due to shelter and wage costs next year. While we agree that goods inflation has probably peaked, markets and the prevailing bias might still be underestimating the speed and magnitude of the policy adjustment required by the Fed if underlying inflation remains persistent.
In recent notes we have presented a few different ways to demonstrate that monetary policy remains exceptionally loose in the United States. The Funds rate implied by the “Taylor Rule” is around 6% and clearly real interest rates are most negative since the peak policy error in the 1970s. While the Fed’s official policy target is core PCE inflation, changes in the funds rate (the reaction function) have been aligned with changes in consumer price inflation as well. Taken literally, the current pace of inflation warrants multiple rate hikes over the coming quarters (chart 1).
As we also noted last week, the reversal of QE would be equivalent to more than 7 (25 basis point) rate hikes even before the Fed increases the funds rate once. That might explain why the 2018 cycle appeared to be so challenging for financial conditions and risk assets. Perversely, forward rate expectations might even suggest that the Fed is committing a different kind of policy error to the one noted above. That is, potentially tightening policy too much. There has been a sharp flattening in the 4yr/1yr – 1y/1yr rates curve (chart 2). That might be another way of highlighting (or adjusting for) the impact of tapering QE on liquidity/financial conditions. Stated differently, the policy error might be leaving normalisation so late that it requires a much sharper reversal of QE and short rates.
In conclusion, our sense is that the Fed is probably well behind the curve and the markets might be too complacent with the belief that more now equals less later. The markets might also be too complacent on where terminal (neutral) rates end up in this cycle, but policy is complicated by the reversal of QE and impact that has on tightening financial and liquidity conditions. In the 2017/2018 cycle, tapering was equal to approximately 300 basis points of tightening. This may help explain the recent material weakness in long duration growth equity, non-profitable technology and liquidity beneficiaries over the past few months (many have declined by 40-60% from peak). It might also explain US dollar strength this year and emerging market under-performance. Of course, that was also exacerbated by credit and liquidity tightening in China. The good news there is that China has commenced policy easing again.