Politicians use the word “inflation” very loosely these days in order to convince their constituents that their problems are the cause of a “Putin problem”. But inflation was starting to be a problem long before the invasion of Ukraine, but now they have the perfect lifeline.
Analysts and fund managers around the world had been discussing the implications for asset allocation due to persistent inflation since the end of Q421. After months of the US Fed deliberately trying to convince us that inflation was temporary, the market refused to believe them, especially bonds and rates. These markets have been signaling a Fed policy error for months, and that was before the war.
After printing more than $5 trillion in stimulus and trillions more in fiscal policy to revive an already stalled economy, the surge in aggregate demand seen in a short time, along with supply chain bottlenecks supply due to Covid lockdowns, have caused one of the largest price spikes in any field we have seen in decades.
We all know that the Fed’s watered-down CPI measure doesn’t even come close to describing what “real” inflation is. The inflation felt by the average household when shopping for groceries or paying utility bills, especially since their wages have not risen by far relative to their cost of living. This is where the serious problem lies. The American consumer is trapped for now.
Yields on US 10-year bonds have risen from 1% in August of last year to nearly 3% today. It may not be so much the absolute level of return as the speed at which it recovers that is of concern. Yields for the entire global bond complex have rallied strongly and the bond complex is down 10% year-to-date in just four months.
These are not normal markets, given the importance of bonds in the asset allocation of pensions and institutions, these types of movements represent huge problems for them. Moreover, the shape of the yield curve is more problematic than the yield itself. The front end of the yield curve falls much faster than the rear, i.e. the yields at the front increase compared to those at the rear which even fall to some extent.
This “inverted” momentum in the yield curve is a signal from the bond market that the Fed is taking too long to contain inflation and is tightening as the global economy slows. It is almost certain that by next year the Fed may have to start cutting rates because something is going to snap. Stock market complacency is based on this very logic that the Fed will eventually ease policy so that it is ready to look beyond any short-term restrictions. But we all know that investments don’t work that way. This blind faith in the Fed’s put is misplaced because this time the Fed’s put strike, the level it would like or even might strike, is far lower than most imagine.
We have average inflation of 8% to 10% year-on-year, levels not seen since the 1980s, and the rate of change for some key commodities is around 30% to 40%. The solution to any problem for them has always been to print more, but now if they did that the global economy would go into recession indefinitely. There is simply too much debt in the system. If one were to look at the CPI and Fed Funds neutral rate, even if the Fed were to raise rates to 3%, it still wouldn’t come close to offsetting inflation in the system. The Fed knows this and therefore all it can do is strangle the market every day by talking about its game in hopes of getting the desired outcome.
Currency markets are also signaling a similar worrying sign. We have been on the road to Japanization for a long time, as our policies have followed in their footsteps for decades. Today the Japanese Yen is falling precipitously as the BoJ has no choice but to continue buying more and more assets. Sound familiar? Given the rise in yields, they have now announced to cap the 10-year at 0.25% by announcing unlimited purchases. They can either drop their currency or let the bond market crash.
We know that the latter is not possible, but it causes huge problems because the more the yen devalues, the more pressure it will put on other Asian currencies as they lose their competitive edge. The Chinese yuan finally broke down against the dollar. Past crises have always emerged from rates or forex markets, and equities players are too busy focusing on buying beat tech names because they seem to be 50% to 60% cheaper not knowing why, but because that’s what they’re used to. .
Stocks are the least sophisticated of all asset classes as they are pushed and pulled from all directions and streams, but ultimately they always catch up with broader market signals. Global economic growth is slowing and leading indicators suggest we may start to see weaker ISM prints. Everyone is calling for a recession in 2023 or 2024, but we may already be in the middle of a recession. The Fed runs the same experiment over and over expecting a different outcome. This time, if the economy faces another hiccup, they can’t get away with it.