The line chart of real 10 year US bond yield and implied inflation expectations (%) showing negative real returns reflects the simple financial conditions

The inflation debate plays a big role in the US market outlook

In a year full of remarkable developments, a critical signal from the US Federal Reserve should not be overlooked by investors.

In a speech in late August, Fed Chairman Jay Powell outlined a new approach by the central bank to tolerate a rate of inflation above the current target of 2 percent in the coming years.

With US inflation at 1.2 percent, this could be a moot point in the short term. However, the Fed’s acceptance of a more inflationary world has intensified a debate in the markets. How long will the central bank go on its extraordinary bond buying to keep interest rates down and support the economy to boost inflation?

Investors have a lot at stake. Bondholders will suffer losses as higher inflation undermines the value of the low fixed rates on their holdings over time. Equity markets could not escape either, as a higher premium is required to offset the higher risk of inflation that is likely to test highly valued stocks.

“People are so used to the idea that inflation is going nowhere and the markets are very complacent. This means a big shift in rates and markets if investors lose confidence in that view, ”said David Bianco, chief investment officer in America at DWS, the wealth manager. “It’s not just the bond market that depends on low interest rates.”

Market expectations for inflation are already rising as the global economy pulls out of the shock of 2020 due to huge fiscal and monetary stimulus. In the US, long-term inflation expectations implied by the inflation market have rebounded sharply from the pandemic lows to their highest levels in 18 months.

According to Bloomberg data, these expectations have only returned to an average of 1.9 percent over the last decade. However, if the Fed continues to suppress yields, inflation expectations may rise further.

Massive government debt purchases this year have meant that nominal government bond yields lag well behind recovering inflation expectations. A US 10-year return of just under 1 percent only bounced back from a low of 0.5 percent earlier this year. In contrast, inflation expectations for 10 years for the next decade have risen from 0.55 percent in March to 1.9 percent.

The divergence between these two measures has kept real returns – the interest rates that keep inflation away from nominal returns – well below zero. A negative real interest rate is when inflation is above nominal returns.

Negative real returns are important because they allow for easy financial conditions. This type of environment is very fertile for risky assets like stocks, while it tends to hurt the strength of the dollar.

These trends are currently in full effect and are likely to continue as the Fed’s last wish is for a reversal of loose financial conditions. That, along with a stronger dollar, could lead to a sharp decline in stocks, both of which would act as disinflationary forces.

The Fed’s new approach is supported by the view that the global damage caused by the pandemic is such that it will take several years to restore full employment. Anchored secular forces of aging populations, innovative technologies, and global labor and capital procurement are disinflationary in nature and are not seen as fading.

The result is a stronger buying of bonds by the central bank to prevent long-term interest rates from rising sharply while tolerating higher inflation.

This all explains why so many investors view the US dollar, the global reserve currency, as bearish. However, a weaker dollar, in turn, increases commodity prices, a major driver of inflation expectations, while increasing the cost of imported goods for US consumers and businesses.

“The real story is from 2022 and beyond,” said Steven Blitz, chief US economist at TS Lombard. A broader economic recovery and the pursuit of higher minimum wages should be well established by then, testing the Fed’s willingness to get the economy going.

However, it could be too late for the Fed to hike rates and halt inflation if investors and the general public believe that soaring prices are returning on a large scale. This is where current policy targets may work too well, driving inflation expectations higher and convincing investors and consumers that a tipping point has been reached.

A logical answer would be a rush of credit to buy assets that appreciate in a more reflationary environment such as gold and real estate. And, thanks to the growing central bank balance sheet, the Fed has plenty of excess reserves from financial lenders that could help boost credit demand.

At the moment, bank reserves created through purchases of central bank bonds are referred to as “cold money” by Mr Bianco: they sit in the financial system and are not lent to the overall economy. However, according to Bianco, those reserves could get much hotter if “a sharp surge in credit growth brings more cash into the economy”. He worries: “As soon as this starts and feeds itself, the inflationary spirit is out of the bottle.”

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