An inflation-free food should scare investors

Last week, Fed Chairman Jerome Powell outlined the last two steps: examining where inflation really is, rather than worrying about where it is expected to be, and clarifying that neither is the current wild excess on the stock market, nor does the recent preparation in bond yields bother him.

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

In the bond market, this version of the story is shown in high inflation expectations for the next five years – a rate of return of 2.51%, although to an extent that is usually higher than the Fed’s preferred level of inflation . In the next five years, inflation expectations are much lower, only 2.11% on Friday; if correct, it would almost certainly mean that the Fed’s preferred measure of inflation would be below its 2% target.

An alternative narrative is much more political and has grown in popularity among investors looking at economic history. It starts with the transformation of the deficit debate. After Obama’s 2009 stimulus, even Democrats were worried about how he would pay, and the popular parallel was with troubled states such as Greece.

This time, the main concern of Democrats, as it is, is that too much spending could lead to inflation.

Of course, Republicans in Congress have rediscovered fiscal probity from the loss of the White House, and most Democrats could not be more fragile. But in the last decade, virtually everyone has come to understand the essential principle of modern monetary theory that the dollar issuer is not flawed.

Here the story moves to the Fed. A Hawkish Fed can counter the White House by spending high on hiking rates. But Mr Powell has pledged not to raise until inflation is sustainably targeted by the Fed and the country is in full swing. Most policy makers believe that this means at least three more years of almost zero rates.

The question is what happens if the goal is reached earlier. If inflation rises rapidly, say up to 3%, will the Fed be willing to raise rates sooner and risk rising unemployment? How about 4%?

Fed decision makers stressed that achieving full employment helps the most marginalized in society. The other aspect is that pushing unemployment up to restrict inflation will affect that group the most. Politically, this makes tighter monetary policy more difficult to justify.

There are also broader issues leading to higher inflation, as Pascal Blanqué, chief investment officer at French fund manager Amundi Asset Management, points out. Growing national rivalry, as well as export restrictions on protective equipment and vaccines, are encouraging companies and governments to secure domestic supply chains, even if this leads to higher costs.

A synchronized global recovery this year will mean upward pressure on commodity prices, a classic source of inflation. And the Covid outage has led to widespread production problems, including a lack of transport containers and critical car parts, which again indicates higher prices.

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

I think it’s safe to leave the flowery bells in the closet. Severe inflation is still very unlikely, although it is now more likely than it was. The job market is much more flexible than in the 1970s, making the wage price spiral difficult, while there is still a lot of international competition to curb companies’ ability to raise prices. These trends could be reversed, but it will take years for unions to build their strength and savings to be reoriented to domestic production.

However, everything is in place for at least one crisis of market anxiety about inflation.

Inflation is poised to rise in the next few months due to a sharp drop in prices a year ago, as Mr Powell himself pointed out on Wednesday. He said the Fed would ignore what was expected to be just a blip. The economy is also likely to grow rapidly; The Newcast Fed’s Newcast Fed model, for example, predicts annualized growth of 6.3% in the first quarter.

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

“Investors are prepared for an inflation scare,” says Dario Perkins, an economist at TS Lombard strategies, even though he believes it is unlikely to last.

The obvious bets to take advantage of an inflationary fear are the opposite of what worked last year: throw away treasurers, throw out high-quality bonds, throw up stocks, buy economically sensitive cheap cyclical stocks, buy goods, buy bonds n .

Overall, the market could rise or fall, depending on its components, as it showed last Thursday: the S&P 500 was pulled down by large declines in growth stocks, even though its cheap and cyclical members suffered less and banks have grown. In Europe, the same pattern has led to market growth, as cheap and cyclical stocks account for a larger share.

Many of these have already happened, because the same trades benefit from economic reopening. So the scare will have to be great to exceed what is already anticipated in the price.

However, a permanent change of regime is not clearly established in the Treasury. Even after last week’s jump, 10 years are still yielding only around 1.7%, and inflation expectations on the long-term bond market have been stable. Investors generally accept Mr. Powell’s pitch and believe that after a short period of higher price increases, the Fed will be willing to assert its independence and keep inflation in line.

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

Real inflation scares badly.

Write to James Mackintosh to [email protected]