The inflation dynamic changed over the last four months, and that has been recognised by the financial markets and the central banks. The focus had been on transitory inflation, which is heavily related to supply-chain problems that resulted from the economic rebound from Covid-19 pandemic lockdowns.
While the market was monitoring transitory inflation normal cyclical inflation started to pick up as output gaps closed. In the US, it is fairly extreme as wage inflation rises. It is a similar story in Europe though wage inflation has been less of an issue so far.
Data released in January showed US consumer price inflation rose by 7% in 2021, higher than economists expected, and the biggest 12-month increase in 39 years. Inflation has become a political problem for US President Biden, who is worried about whether voters might channel their frustrations about higher household expenditure into the voting booth during the mid-term Congressional elections in November. This in turn has forced the US Federal Reserve (Fed) to become more hawkish.
We think the transitory inflation, the supply bottlenecks, have started to ease. You can see that in manufacturing data and delivery times. This is positive but cyclical inflation is a little more problematic.
Higher prices impacting consumer sentiment
University of Michigan Consumers Survey on Buying Conditions for Large Household Durable Goods
Source: University of Michigan, Surveys of Consumers, December 2021
The reaction in financial markets to the Fed meeting in January – and the December meeting – was dramatic and, in my view, excessive. The market has priced in five interest rate hikes by the Fed in 2022, which is getting to extreme levels. The view is that the recovery is strong, the omicron variant of Covid-19 appears to be fading, inflation is high and the politics around inflation are getting difficult.
What happened after the Fed meeting was that the dollar strengthened, the yield curve flattened, and equity markets fell sharply. Since then, the Fed has backpedalled somewhat, saying that they don’t want to upset markets.
Focus on tightening
What the Fed does want is a steep yield curve and a weaker dollar. The Fed recognises that bad things happened in the past when they have over-tightened and caused the dollar to rocket higher, with all instances ending with market falls and the Fed having to add liquidity. My view is that the Fed is going to use quantitative tightening (QT) to reduce the size of the bank’s balance sheet by slowing the purchase of bonds in a bigger way this time.
More than five hikes next year are possible and not our base case but the difference being, with the European Central Bank finally also tightening it should not be too upsetting for markets as real yields rise everywhere and the dollar remains subdued.
Although they say the main lever to control inflation is interest rates, I believe they are going to use a high level of QT, probably winding down bond purchases by about $100 billion a month. They hope this will allow them to go easier on policy rate cuts and can tighten without sending the dollar up sharply.
The Fed has hiked interest rates too much in the past, and the result has been they’ve had to backpedal as markets react, and no one wants to buy their bonds because the dollar strengthens and there is a dollar shortage. This time they have put together liquidity vehicles, including repo facilities and the FX swap facility. They are saying, `Yes, we will be buying fewer bonds under QT, but if anyone needs dollars, come to us. Keep buying our bonds.’ They have set this up, so they are able to do more QT than front-end interest rate hikes.
Five rate hikes in 2022?
So, I think five rate hikes this year is likely the ceiling. That said, more rate hikes will need to be priced in for the future. The economy is cooling, but there must be more evidence that inflation from the supply side is coming down. That is important for markets. Once you see more evidence of that, the Fed can go easy, along with other central banks, including the European Central Bank.
In this scenario of synchronised global growth, it would make sense to sell dollars, buy emerging markets assets and to sell developed market sovereign bonds. Investment grade credit may struggle to make returns.
The main risks to this scenario are that that US inflation remains elevated, which would cause more near term hikes. Geopolitics is another risk — if it causes investors run to the dollar for safety. China growth is another risk. It would be a mistake if China maintains its zero Covid policy – this could have reverberations on global growth.
The main risk for risky asset markets is that real rates across all markets are too low if the central banks want to properly address the inflation issue.
At the time of writing, I don’t see a policy mistake happening. I think the central banks can get on top of inflation without excessive rate hikes. This will allow the yield curve to stop inverting, and the market can stop predicting doom. The dollar can remain weak – that is good for global growth. It is possible to have synchronised global growth.
When safe havens are hard to find
Macro Monitor: Rates higher for longer?
Are recession concerns overdone?
Macro Monitor: Big macro changes are brewing…
Examining the knock-on effects of the Ukraine crisis for fixed income investors
The value of active minds: independent thinking