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Markets Keep Making the Same Mistake About Inflation
The danger is that stocks and bonds have further to fall because investors are still clinging to the vestiges of the belief that inflation will soon be conquered
By James Mackintosh
Investors made a huge mistake over the summer, misreading the economy and, even worse, misreading the Federal Reserve. The scale of the mistake became obvious on Tuesday and led to the biggest one-day selloff in more than two years.
But the error—a belief that peak inflation will allow the Fed to ease after reaching peak rates early next year—continues to underpin bond, stock and futures prices.
The mistake is an easy one to make, because—barring hyperinflation and the collapse of society—inflation will eventually return to low levels. But investors have been far too optimistic that it will happen soon, in the face of lots of evidence that inflation is stuck well above the Fed’s 2% target and clear warnings from the Fed that the market has it wrong.
The danger is that stocks and bonds have further to fall because investors are still clinging to the vestiges of the belief that inflation will soon be conquered, a bad recession avoided and so the Fed freed to pause, then ease.
Tuesday’s inflation figures destroyed the idea that the Fed would pause soon. Excluding volatile food and energy, prices rose 0.6%, which if sustained would be an annual rate above 7% and higher than any time from 1991 to the pandemic.
Other methods used by the Fed to extract signal from noise were similarly awful: the median rise, an average that trims off the biggest and smallest price changes, and the rise in “sticky” prices that aren’t changed very often.
Markets responded as they should. Bets on rate increases shifted to put a one-third probability on a full 1-percentage-point rise at next week’s meeting, something the Fed hasn’t done since 1984. Peak rates are now expected to be reached a month later, in March, and be higher than previously thought, above 4%.
But hope lives on, with the evidence of it showing up both in stocks and in bets on the Fed.
The stocks most sensitive to bond yields are those where most earnings come far in the future, so-called growth stocks. They were clobbered by rising bond yields in the year up to mid-June, then rebounded the most as bond yields retreated, and have been hit again as yields have risen since mid-August.
So far, so normal, at least for recent years. Yet the 10-year Treasury is now within a whisker of its mid-June high of 3.48%, while growth stocks have only lost about half what they gained in the two-month summer rally that ended in mid-August.
Something’s up, and that something is hope. Back in June investors seemed to have capitulated, but increasing hopes that inflation would fade away and the Fed be able to relax drove the S&P 500 up 17% over the summer. About half the gain has been lost, but investors are still clinging to the belief that things will soon get better.
To be fair, some things are getting better. The easing of Covid-19 restrictions and a shift in demand from goods to services has eased congestion in ports, trucking and microchip supply.
The price of oil is around $90 a barrel, from above $120 in June. Important commodities such as copper have fallen more than 20% from this year’s highs. And shipping costs have collapsed, which should quickly feed through into prices in stores. The crisis in Europe and China’s housebuilding crash and endless Covid-19 lockdowns should help damp global demand, too, reducing pressure on consumer goods.
All that helps explain how investors are able to cling to their belief that the Fed will pause its rate rises early next year and begin easing again by the end of the year.
And it isn’t a stupid belief! Monetary policy famously has long and variable lags before it hits the economy, so even the first cautious rate rise from March may not have had its effects yet, let alone the far bigger ones that followed. Next year these higher rates should be weakening demand, while less will be left of the pandemic-era savings that have helped support spending. The combination of weaker demand and improved supply is perfect for lowering inflation.
Yet, overall demand remains strong, wages are growing fast and there are few signs of the sort of economic trouble that would crush prices. Worse still, Fed policy makers keep dismissing the idea that lower rates could follow quickly after a pause.
The one thing almost sure to prompt the Fed to cut rates would be a recession, as a shrinking economy usually crushes demand and brings price rises to a halt. But markets aren’t seriously preparing for a recession, with bets instead assuming inflation comes down sharply without killing the economy.
Corporate-bond prices suggest a higher chance of the very weakest companies going to the wall. But junk bonds yield only 4.68 percentage points above Treasurys, according to the ICE BofA US High Yield index, well below even the recession scare of December 2018, let alone actual recessions.
Stock prices started to show concern about recession a few months ago, and mutual-fund managers surveyed by Bank of America say recession is more likely than not. But recession has remained secondary to valuations—a proxy for sensitivity to changes in rates—as a driver of prices, with highly valued stocks falling most when bond yields rise.
Overall, this remains a single-bet market. If you believe inflation will come down by itself and the Fed responds by lowering rates next year, stocks and corporate bonds make sense. If you think the Fed will do what it says, they’re still overpriced.
