In a year replete with striking developments, one critical signal by the US Federal Reserve should not be overlooked by investors.
In a late August speech, Fed chair Jay Powell outlined a new approach by the central bank to tolerate a pace of inflation above its current target of 2 per cent in the coming years.
With US inflation running at 1.2 per cent, it might seem a moot point in the near term. But Fed acceptance of a more inflationary world has intensified a debate in the markets. How long will the central bank continue its extraordinary run of bond buying to keep interest rates down and support the economy in an effort to push inflation higher?
Investors have a lot at stake. Owners of bonds will suffer losses if higher inflation erodes the value of the low, fixed interest rates on their holdings over time. Equity markets might not escape either, with the need for a bigger premium to compensate for higher inflation risk likely to test richly valued shares.
“People are so accustomed to the idea that inflation is not going anywhere and markets are very complacent. That means a big dislocation in rates and markets when investors lose confidence in that view,” said David Bianco, chief investment officer in the Americas for DWS, the asset manager. “It’s not just the bond market that is dependent on low interest rates.”
Already, market expectations of inflation are on the rise as the global economy pulls out of 2020’s shock on the back of enormous fiscal and monetary stimulus. In the US, long-term inflation expectations implied by the bond market have rebounded sharply from pandemic lows to their highest in 18 months.
These expectations are only back at their average of 1.9 per cent seen for the past decade, according to Bloomberg data. However, if the Fed keeps suppressing yields, inflation expectations can rise more.
Massive purchases of government debt this year have resulted in nominal Treasury yields significantly lagging behind rebounding inflation expectations. A US 10-year yield shy of 1 per cent has only picked up from a low of 0.5 per cent earlier this year. In contrast, 10-year inflation expectations for the next decade have jumped from 0.55 per cent in March to 1.9 per cent.
The divergence between these two measures has kept real yields — interest rates that strip out inflation from nominal returns — stuck well below zero. A negative real rate occurs when inflation runs above nominal yields.
Negative real yields matter because they facilitate loose financial conditions. That kind of environment is very fertile for risky assets such as equities, while it tends to sap the dollar’s strength.
These trends are in full force at the moment and will probably continue, because the last thing the Fed wants is a reversal of loose financial conditions. That could lead to a sharp pullback in equities alongside a stronger dollar, both of which would act as disinflationary forces.
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