The much-watched US Consumer Price Index (CPI) rose by 6.2% on an annualized basis, its highest level since 1990. Higher energy and food prices were principally blamed, though the index still rose by 4.6% when these factors were stripped out.
This caused the US Federal Reserve to change its view on inflation from a ‘transitory’ phenomenon to something more permanent during a 30 November testimony by Chairman Jerome Powell to the US Congress, catching markets by surprise.
Equities dropped on fears that a much faster unwinding of stimulus programs (tapering) to combat inflation would be followed by the earlier introduction of the first rate rises since they were cut in March 2020 to combat the pandemic. Bond market gains on the new omicron Covid strain were reversed as they started to price in an earlier rise in rates, now seen in May 2022.
“Bond markets globally are faced with rising inflationary pressures and the Fed has now moved away from this ‘transitory’ narrative, which opens the window for faster tapering,” says Peter van der Welle, strategist with the Robeco multi-asset team.
“The Fed funds futures curve steepened in reaction with market participants bringing rate hikes forward in time, with the May 2022 FOMC meeting now seen a ‘live’ (rate-setting) meeting.”
“Based on the swaps curve, rate hike expectations seem to be peaking at around the 1.75% level (up from the current 0.25%). This implies a relatively low terminal rate compared to previous hiking cycles, which is having a gravitational pull on the yields of US 10-year Treasury bonds.”
Sting in the tail
Equities were already reeling from the announcement of the more contagious omicron variant of Covid-19 which prompted flight bans and more containment measures in Europe, particularly hurting travel and hospitality stocks.
That was still being absorbed when Powell commented that the Fed should “consider wrapping up the taper of our purchases perhaps a few months sooner”, given that “at this point the economy is very strong and inflation pressures are high”.
“November is typically a fairly good trading month for equity markets, on average adding 1% to year-to-date returns,” says Van der Welle. “Not so this time around, with global equities dropping 1.5% in the month. The sting in the tail was provided by Powell’s Congressional testimony which caught analysts by surprise.”
Good and bad inflation
“This is a hawkish pivot away from the ‘inflation is transitory’ mantra. At this juncture the Fed is accentuating the hawkish overtones as it has grown more uncomfortable with inflation. The level and speed of inflation increases the risk of second-round effects and entrenched inflation.”
“The nature of inflation matters. Current inflation is not predominantly of the ‘good’ type – the non-accelerating type that coincides with an economy that is operating in equilibrium. Instead, the global economy is experiencing bad inflation caused by supply constraints which ultimately could pave the way for ‘ugly’ inflation.”
“Given the ongoing strength in the US labor market, the potential for this kind of ugly inflation that stems from a wage-price spiral is increasing on the back of improved negotiation power of labor versus employers.”
New twist from omicron
Van der Welle says Powell acknowledged that the Fed had misjudged inflation as demand was artificially supressed by the pandemic while supply-side pressures created non-linear effects that escaped the normal macro models.
“The new omicron Covid strain adds further momentum to Powell’s latest twist,” he says. “The OECD has warned that inflation will only abate once the pandemic is over. A new strain could lengthen the battle against Covid and thereby inflation.”
But it’s not all bad news, following a stellar US third-quarter earnings season that shows companies are still gaining pricing power, which bodes well for equities.
There are also questions over the chronology of tapering and higher rates as much depends on the US participation rate – the number of people active in the labor market – which gives an indication into the true strength of the economy.
Participation vs. policy rates
“We continue to think that the end of tapering does not mean a seamless transition into a rate hike cycle, as the Fed ideally would see a higher participation rate before raising the policy rate,” says Van der Welle.
“We expect inflation to moderate in 2022 and this provides the Fed with some leeway to assess whether part of the decline in the participation rate is cyclical. Ultimately, it is not so much the policy rate lift-off date that matters for equity markets, but the degree of tightening versus the terminal rate.”
“With the probability of an over-tightening Fed low in the near term, the US economy will be able to absorb the first policy rate hikes and will continue to grow at a healthy pace in 2022.”
“Meanwhile, flare-ups in infections and the discovery of new Covid variants may trigger temporary risk-off phases that will be beneficial for government bonds.”