Market Forecasts vs. Fed Rhetoric

by | March 22, 2021

The past week witnessed a return of investor concerns, manifest in rising global bond yields and unsettled equity markets. Stock markets dipped, with investors shifting out of riskier cyclical stocks back into the relative safety of large capitalization growth and technology shares. The US dollar gained, while oil and other commodity markets softened. At the margins, markets girded themselves.

Investors remain fixated on bond yields, which have continued to rise and are now at their highest levels in over a year. The growing consensus is that a combination of powerful policy stimulus and effective vaccination against Covid-19 will push growth and inflation higher. 

That is unambiguously good news, which ought to be greeted on Main Street as well as Wall Street. So why are investors losing their nerve?

The problem is that investors have largely discounted the best of all possible worlds—strong growth, stable inflation, rising profitability and easy money. If any of the ‘big four’ come into question, the underpinnings for the market will be called into question.

A return of the pandemic could derail markets. Yet despite concerns in the medical establishment about new and potentially more lethal mutations of the Covid-19 virus, investors don’t share that concern. Otherwise, growth jitters would be pushing bond yields lower.

Nor are investors fretting about profitability. Consensus expectations call for over 20% profits growth in major markets this year, led by a resurgence of earnings from beaten up cyclical and value sectors, such as financials or energy.

Rather, investors are fixated on the potential for tension between growing inflation expectations, which have driven nearly two-thirds of the rise in bond yields over the past six months, and central bank commitments to easy monetary policies.

The emerging concern is that Fed policy may be time inconsistent. Today, the Fed pledges that it will tolerate an overshoot above its 2% inflation target. But when that overshoot arrives, will it hold its nerve?

Perhaps, but it is already proving difficult for the Federal Reserve to convince investors. The challenge for the Fed is that massive fiscal and monetary stimulus, alongside credible hopes for economic re-opening, are pushing up long-term inflation expectations. Based on ten-year Treasury note pricing, markets already anticipate a decade of inflation above the Fed’s 2% target. Treasury yields also suggest that, for the first time since late 2018, US five-year average inflation in five years will also exceed the Fed’s target.

The Fed’s language of a temporary inflation overshoot is being questioned by the markets.

To be sure, the overshoot of long-term inflation expectations relative to the Fed’s definition of price stability remains modest. But the trend is unmistakable. Investors are beginning to anticipate a quicker and more durable return to symmetric inflation risk than at any time in the past three years. 

And that is where the rubber meets the road.

Specifically, the symmetry of market forecasts is beginning to clash with the asymmetry of Fed rhetoric. Jerome Powell and the majority at the Federal Open Market Committee (FOMC) are committed to an overshoot of the Fed’s 2% target for core inflation, largely because they believe that well-anchored long-term inflation expectations will deliver price stability in the long run. Fed policy is based on a conviction that inflation risk is asymmetric – potentially too low, unlikely to be too high.

Market pricing suggests investors are not so certain. And that’s a problem. Merely the arrival of doubt is sufficient to produce a change in risk premiums. Put differently, even if the Fed’s aims are ultimately achievable, the path from here to there is becoming sufficiently uncertain to demand a re-pricing of monetary policy commitments. That is enough to rattle markets.

But, ultimately, even more is at stake – the Fed’s credibility.

By its own admission, the Fed’s 2% inflation target rests critically on stable long-term inflation expectations. If those expectations, in the Fed’s own parlance, become ‘un-anchored,’ the Fed will lose its most important pillar of its overshooting policy commitment. In that case, even a temporary overshooting of inflation poses a grave risk to the Fed’s long-term price stability mandate. 

Rising long-term inflation expectations could also expose the Fed to a distressing dilemma should they coincide with a divergence between strong economic growth and seizing up financial conditions. Specifically, if rising inflation expectations and improving economic fundamentals coincide with falling stock and bond prices, will the Fed be able to ease without putting in jeopardy its credibility? 

Merely posing that question, as markets are now doing, risks eroding investor sentiment. To emphasize, market pricing today is reliant on hopes for continued easy money, as well as economic recovery.

In sum, the Fed and markets are committed to beliefs that could prove time inconsistent. Pledges made today, may be impossible to keep. That is the fault line of the Fed’s overshooting policy commitment. 

This coming week, in various speeches and testimony, Fed officials and Chairman Powell may have to address awkward questions about market re-pricing and the pledges they have made. Most probably, the Fed will double down, emphasizing a belief that higher inflation will be transitory. 

Yet markets already recognize the potential for time inconsistency and the dilemmas it poses for investment strategy and Fed policy. Investor nerves are being tested in ways that won’t easily go away. Markets are likely to get more interesting in the weeks and months to come.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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