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.