A Fed without fear of inflation should scare investors

Last week, Fed Chairman Jerome Powell underlined the final two steps: looking at where inflation really is, rather than worrying about where it is forecasted, and making it clear that neither the current wild excess in the stock market nor does the recent rise in bond yields bother him.

The change should lead to a reevaluation of the dominant market narrative. So far, the assumption has been that the Fed will tolerate some short-term inflation created by President Joe Biden’s $ 1.9 trillion stimulus, but that in the long run the Fed will regain control or inflation will disappear on its own.

In the bond market, this version of the story appears in high inflation expectations for the next five years – a breakeven rate of 2.51%, although to a extent that typically reaches higher than the Fed’s preferred inflation indicator. For the next five years, inflation expectations are much lower, just 2.11% on Friday; if correct, it would almost certainly mean that the Fed’s preferred inflation measure would be below its 2% target.

An alternative narrative is much more political and has grown in popularity with investors looking at economic history. It all starts with the transformation of the deficit debate. After Obama’s encouragement in 2009, even Democrats were concerned about how it would be paid, and the popular parallel was with troubled states like Greece.

This time, the Democrats’ main concern, as it stands, is that spending too much can cause inflation.

Of course, Congressional Republicans have rediscovered fiscal probity since they lost the White House, and most Democrats couldn’t be more fragile. But in the past decade, virtually everyone has come to understand the basic principle of modern monetary theory, that the dollar issuer does not go bankrupt.

Here, the story goes to the Fed. A Hawkish Fed can neutralize White House spending by raising rates. But Powell did not commit to any hike until inflation is sustainably at the Fed’s target and the country is in full employment. Most policymakers think this means at least another three years of near-zero rates.

The question is what will happen if the goal is reached earlier. If inflation rises quickly, say to 3%, will the Fed be willing to raise rates earlier and risk an increase in unemployment? How about 4%?

Fed policymakers have emphasized that achieving full employment helps the most marginalized in society. The flip side is that increasing unemployment to curb inflation will hit that group more. Politically, this makes tighter monetary policy more difficult to justify.

There are also broader issues that push for higher inflation, as pointed out by Pascal Blanqué, director of investments at the French fund manager Amundi Asset Management. Growing national rivalry, as well as restrictions on the export of protective equipment and vaccines, encourages companies and governments to secure secure domestic supply chains, even if this entails higher costs.

A synchronized global recovery this year will mean upward pressure on commodity prices, a classic source of inflation. And Covid-related disruptions have led to widespread production problems, including a shortage of shipping containers and essential car parts, which again points to higher prices.

“There is a continuous shift from the narrative of secular stagnation to what I call the way back to the 1970s,” says Blanqué.

I think it’s safe to leave the flowered bell pants in the closet. Serious inflation is still very unlikely, although it is now more likely than it was. The labor market is much more flexible than in the 1970s, making wage and price spirals difficult, while there is still a lot of international competition to restrict companies’ ability to raise prices. These trends may be reversed, but it will take years for unions to build their power and economies to be redirected towards domestic production.

However, everything is ready for at least one surge of market anxiety about inflation.

Inflation is expected to rise in the coming months due to a sharp drop in prices a year ago, as Powell himself pointed out on Wednesday. He said the Fed would ignore what he hoped was just a speck. The economy is also likely to be growing rapidly; the New York Fed’s Nowcast model, for example, predicts annualized growth of 6.3% in the first quarter.

Combine that with a commitment to low rates and a president already moving on to his next spending plan, and it makes sense for people to be more concerned about rising prices.

“Investors are prepared for fear of inflation,” says Dario Perkins, an economist at strategist TS Lombard, although he thinks it is unlikely to last.

The obvious bets to profit from the inflation scare are the reverse of what worked last year: dropping Treasury bonds, dropping high-quality bonds, dropping growth stocks, buying cheap and economically sensitive cyclical stocks, buying commodities, buying junk bonds .

The market as a whole may rise or fall, depending on its constituents, as shown last Thursday: The S&P 500 was dragged down by huge declines in growth stocks, even with its cheap and cyclical members suffering less and banks going up. In Europe, the same pattern led to an increase in the market, since cheap and cyclical stocks have a larger share.

Much of this has already happened, as the same businesses benefit from the economic reopening. So the scare will have to be big to overcome what is already foreseen in the price.

However, a permanent regime change is clearly not included in the Treasury price. Even after last week’s jump, the 10-year index still yields only about 1.7%, and long-term bond market inflation expectations have remained stable. Investors, in general, accept Powell’s proposal and think that, after a brief period of higher price hikes, the Fed will be willing to assert its independence and keep inflation under control.

If the market loses confidence, long-term Treasury yields are expected to rise even faster, the dollar would fall and stocks that are more dependent on profits in the distant future, Tesla thinks, will be hit hard.

The real scares of inflation hurt.

Write to James Mackintosh at [email protected]