THU 10 MAR 2022
An common expression that winds me up with reference to markets is “uncertainty” – markets are always uncertain by definition because human beings cannot see the future. To be fair, macro variability or volatility clearly widens the distribution of possible outcomes, especially during phases of higher inflation.
While the conflict in Europe has clearly also exacerbated the growth/inflation outlook, the latter is already at multi-decade highs and a widely appreciated risk for markets. Of course, policy rates are still at multi-decade lows and entirely inappropriate for current macro conditions. The Fed probably has very little discretion on rates, despite the parallel downside risk to growth from the war in Ukraine. The good news is that headline US inflation will likely peak in February (reported tonight). The bad news is that inflation is so elevated that the Fed will be forced to hike rates at the March FOMC next week.
The US February consumer price index report is released tonight and is likely to be around 8% at an annual rate. That should not be a surprise to anyone as pressure has clearly been building for some time. However, what has possibly changed over the past few weeks is that breakeven inflation has become more unhinged, even at the longer end of the curve (chart 1). Even 10 year breakeven inflation has started to become unhinged in the United States and elsewhere.
Another aspect of inflation that has concerned us over the past few months is the breadth of the price increases. The Cleveland Fed measures this by observing the “trimmed mean” which takes off the tails of the distribution. This is something that the Reserve Bank of Australia has measured for sometime as a more accurate measure of underlying inflation. The trimmed mean is literally “off the charts” in the United States relative to the policy rate (chart 2).
The good news is that headline consumer price inflation is probably near a peak, in spite of the recent commodity squeeze (chart 3). Indeed, spot prices have increased so much that they will likely cause demand destruction over the coming weeks or months. On the negative side, the key driver of underlying inflation is wage pressure and that is probably consistent with a further rise in core prices over the coming months.
For markets, inflation expectations are also reflexive or self-reinforcing and hence why we are concerned about the recent move in break even inflation and other measures or beliefs. We would also push back on the prevailing bias that inflation has been caused by supply chain disruptions. Rather, the latter was exacerbated by excess demand caused by aggressive fiscal policy (stimulus) and monetary policy. Therefore, the Fed can influence that element of inflation by hiking rates. Consumer price inflation is also having a visible and non-trivial impact on consumer sentiment.
In conclusion, there is a total mismatch between long end inflation expectations and the level of real and nominal yields. The Fed must respond to make holding cash more attractive. While an increase in the discount rate is widely anticipated, the magnitude of the required tightening might still be underestimated and therefore the risk premium on US equity is insufficient, in spite of the recent phase of global risk aversion. As we noted yesterday, our sense is that markets are still missing the cathartic flush typically associated with outright capitulation. Macro (inflation) volatility often begets market volatility as it is a key influence on the discount rate and expected future profit margins.