This week there are two great pieces of news to celebrate in the markets. The first is obvious: a fairly effective vaccine against Covid-19 is being developed by Pfizer and BioNTech. Anthony Fauci, the leading U.S. infectious disease expert, told the Financial Times he was expecting a second one soon.
This has raised hopes for an end to the coronavirus lockdown in 2021. Investors have begun to position themselves for an economic rebound: 10-year government bond yields have risen to 1 percent, and value stocks have risen, while many tech groups have declined (the latter were seen as the main beneficiaries of lockdowns ).
The second piece of good news, however, is not that self-evident, and many policymakers wouldn’t call it that at all: There is growing market chatter about the idea that long-dormant inflation risks may return.
This week, Goldman Sachs warned clients that a key theme for 2021 will be a sharp steepness in the yield curve, which is the difference between short-term and long-term rates in the face of inflation concerns. British asset managers Ruffer and Willis Owen are also talking about it. They cite graphs of 20th century financial history showing how prices typically rise after recession shocks, usually due to government reflation measures.
Some government officials too. “I think investors need to start thinking about inflation again,” US Secretary of Commerce Wilbur Ross told me this week. Mr. Ross does not anticipate “inflation spiraling out of control,” but believes a zeitgeist shift around inflation is looming and this could lead to a re-rating of the market. This could make investors more cautious about bonds, especially given the number of bonds the government will have to sell to deal with yawning deficits.
Federal Reserve officials would be different; in fact, many might ridicule this chatter as dangerous. After all, the data currently shows no price pressure: the core consumer price index in the US fell sharply during the pandemic and is now around 1.6 percent.
The latest US figure could be an understatement. This week, IMF economists suggested that global inflation was under counted by about 0.23 percentage points during the pandemic, as statisticians did not update their consumption metrics to reflect how the lockdown changed spending patterns.
Even if “real” US inflation is closer to 2 percent, that remains within the Fed’s target range, especially given that Fed chair Jay Powell said in August that 2 percent is no longer a cap, just a cap an average goal over time.
Furthermore, Fed officials don’t see higher inflation on the horizon. This is partly because they expect demand to remain weak for some time: As Powell explained last week, they believe the spread of Covid-19 will stifle consumer activity for the foreseeable future. His British counterpart, Andrew Bailey, shares this view.
The other reason Fed officials believe the 20th century inflation patterns are unlikely to recur is because of digitization. Even before the lockdowns, consumers and executives were able to make online purchases for services, goods and workers, fueling global competition. The pandemic has made this worse. If digitization lowers labor costs in many sectors in the foreseeable future, it will keep inflation low.
You are probably right, unless a new outbreak of protectionism naturally leads to the collapse of digital integration. This means the current inflation chatter may be overstated, but the mere fact that investors are talking about these risks is actually a good, not a bad, thing.
In recent years the markets have become dangerously dependent on a one-way bet. Inflationary pressures seemed so unexpectedly subdued prior to the pandemic that investors pretended they would never return. Then in September, Mr Powell promised to keep nominal rates at their lowest levels through 2023. Since then, investors have become even more dependent on free money, or more precisely real interest rates, which were actually negative.
This has fueled complacency with long-term risks in the bond markets. It also sparked the creation of some funky financial structures. A specific acquisition company is a case in point: Spacs have seen a boom this year. Financiers tell me that investors like them because the structure not only offers a possible long-term uptrend in the stock market, but also a short-term warrant with a yield that is slightly superior to T-bills.
Many investors know full well that zero rate bets will suffer if interest rates suddenly rise. But they also know – to paraphrase the banker Chuck Prince shortly before the financial crisis – that financiers have to keep dancing if the free money music keeps playing.
So this week’s inflation chatter is good news. It is unlikely that rapid price growth in and of itself will soon pose a risk to the real economy. What could pose a risk is if the market remains blindly dependent on free money and then experiences a shock when conditions change.
If investors start shifting their portfolios now to pursue a less imbalanced vision of the future, it will help reduce that risk. Fed officials would be foolish to prevent this from happening; Whatever happens to a Covid-19 vaccine.