The markets have remained focused on the Fed (and occasionally the Bank of England), and the Fed has kept its focus on the trailing reported inflation data (CPI, PCE, etc.) and on the labor market data (job growth, wages, etc.). The Fed’s view is that inflation cannot sustainably come down to a suitable level (2-3%) unless income growth slows down significantly. That is, income growth must decline to reduce excess demand. This certainly makes sense up to a point, but of course prices are determined by the combination of demand and supply.
Short-term movements in stocks, bonds, and currencies continue to be driven primarily by changes in investor perceptions about the Fed’s likely course of action over the next 6-12 months. In response to client questions, the following are some comments and charts reviewing recent history and the current backdrop.
The August CPI report released earlier this month was significantly worse than expected, and data since then has not changed the broader view of inflation for the Fed. Along with continued hawkish public commentary from Fed officials, this has driven a further rise in bond yields to new multi-decade highs, and cemented expectations for further aggressive rate hikes by the Fed.
However, despite the “hot” CPI reports, the level of expected inflation in five-year inflation swaps (the most direct way to bet on future inflation) has fallen to its lowest level in a year, and was recently trading around 2.6% (chart below), close to the Fed’s presumed target of about 2.5% on the CPI (dashed line). A similar picture is seen in the 10-year inflation swaps.
Yesterday’s decision by the Federal Reserve to raise rates by 75 basis points for a second consecutive time was historic, as it marks the most aggressive back-to-back rate hikes (150 basis points in less than two months) since the early 1980s, before the Fed was formally targeting the fed funds rate as its key policy focus.
The Fed’s statement and press conference yesterday clearly indicated that the Fed is not done with raising rates yet, but gave some of the first indications that they are acknowledging the signs of slowing economic growth and that the lagged effects of the rate hikes to date have not been fully felt yet. Markets reacted favorably to the news (75bps was well anticipated before the meeting), as it brings the potential for smaller rate hikes and the eventual end of the rate hike cycle closer.
Markets remain volatile, but the narrative driving the volatility has been shifting recently, a topic we have written about and discussed with clients recently. For much of the year, the concern was that the economy was “too strong” and inflation was out of control, and thus the Fed would need to raise rates and reduce their balance sheet quite aggressively to combat inflation. The Fed has taken several steps in that direction, but now conditions have changed such that investors are more worried about growth slowing too quickly and turning into a recession rather than excessive inflation.
Yesterday’s Fed policy announcement was certainly the focus of attention, and monetary policy has been driving headlines and market action for much of the year. However, our view is that fiscal policy is likely the bigger policy force in the economy nowadays, and fiscal tightening started some time ago.
Equities, and asset prices in general, have seen a return of volatility during January, following over a year of very subdued volatility and strong returns. Why, especially in a historically favorable seasonal period? In our view, markets are adjusting to the indications of moderately tighter monetary and fiscal policy following a period of extraordinary support from both US macro policy drivers. Investors are debating whether policy makers will be able to reduce stimulus and inflation pressures without provoking excessive economic weakness, and this debate is showing up as volatility in markets.
Macro uncertainty is provoking volatility
Inflation remains a hot topic among investors, policy makers, and voters. While there is not a great deal that policy makers (fiscal or monetary) can do in the short term to control inflation (today’s announcements of coordinated releases from strategic oil reserves are mostly a signaling action), there are steps that can be taken on a longer horizon. Monetary policy has historically been the primary lever used to try to manage inflation, though it has arguably been less effective in recent years as it has run into the “zero lower bound” (ZLB) with short-term interest rates. Fiscal policy is likely a more potent lever but historically has not been used as such.
A frequent question lately has been: are we currently in, or about to enter, a period of “stagflation” like the late 1960s and 1970s as a result of COVID and policy responses? Our short answer is no: while inflation may be elevated for a while, growth is currently strong, structural inflation pressures are low, and policy is better now than in the 1970s, making any sustained stagflation conditions unlikely. Below we offer some historical context and our current views.
Major equity indices globally have been remarkably stable in recent months, pushing realized volatility readings to very low levels.
Our own research along with that of many others has shown that volatility in equities tends to be persistent in the shorter-term, while tending to mean-revert in the long-term.
Beyond the movements of a single index like the MSCI ACWI or S&P 500, we can also see that the average three-month volatility across a broad array of major developed markets individually is extremely low (chart below). This average of 18 countries’ volatility (based on their respective MSCI country equity benchmark index) is in the bottom decile of its 10-year range right now. This means that it is not just the dominant US market that has had low volatility, nor is it only the diversification effects that can dampen volatility in a broad global index, it is in fact a global pattern of low equity market volatility across many markets.