Economy

Highlights Investors and consumers expect that inflation will remain quite high over the next year, but they are unconcerned that upward price pressures will last: According to surveys and market prices, inflation will exceed 4% next year before subsiding over the longer term to the comfortable levels of the last two decades. The Fed also views elevated inflation as a near-term phenomenon and accordingly expects to hike the fed funds rate at a deliberate pace: The Fed is on the same page as the hoi polloi, and is not gearing up to remove accommodation with any particular haste. While the decade following the financial crisis demonstrated that extremely easy monetary policy does not by itself promote high inflation, the landscape has changed: A decade of ZIRP and QE failed to produce any dire effects, but it remains to be seen how extreme monetary and fiscal accommodation will interact. We expect the bull market will end once the Fed falls behind the curve on inflation and is forced to tighten monetary policy aggressively to catch up: We think the bull has another year to run, but excessive stimulation will eventually bring about its demise. Feature For most of the year, every discussion with our investor-clients has eventually worked its way around to inflation. How high is it going to go? How long will it last? What will it mean for the economy? What will it mean for stocks? How will the Fed react? As the year-over-year change in the Consumer Price Index has climbed steadily higher, breaking above 6% last month for the first time in 31 years (Chart 1), the tenor of the conversations has shifted. Investors have come to recognize that the economy is subject to upward price pressures that are more than the temporary by-product of pandemic base effects. Inflation is nonetheless still largely viewed as a temporary phenomenon that will fade once reopening supply bottlenecks can be resolved. While markets are resigned to another year of high inflation, they are secure in the notion that the disinflationary currents of the last several decades will squelch them over the longer term. Chart 1Long Time, No See The tension between the competing ideas that both inflationary and disinflationary currents are real sets up a potential market showdown. If it is only a matter of time before disinflationary forces return to smother today’s post-COVID disruptions, the widely shared consensus view that the fed funds rate will meander its way to a peak of 2% will be validated. The equity bull market will continue, albeit at a slower pace, until it dies of natural causes. Markets could be in for a rude awakening, however, if the forces supporting higher prices outlast the pandemic and overcome the long-running disinflationary trend. This report considers how inflation could ruin the party. Our base-case view is that the Fed will find itself behind the curve. When it does, it will be forced to tighten monetary policy fast and furious, moving more swiftly to a higher terminal fed funds rate than markets currently expect. That will bring down the curtain on the bull market in risk assets and it may also spark the next recession, but we think the good times will last for at least one more year. What Markets Expect: Inflation Despite all the attention higher prices have drawn, investors haven’t gotten too worked up over them. Although they’ve made considerable revisions to their near-term expectations, their expectations for inflation ten years from now haven’t budged since the start of the year. As the Treasury1 (Chart 2) and CPI swaps (Chart 3) markets show, big consumer price increases are expected to be concentrated in the next year, come off the boil in year two and then slowly cool over the next few years. At the back half of the 10-year curve, year-over-year CPI increases are expected to settle into the range that prevailed during the nineties’ and early 2000s’ inflation moderation. Financial markets do not exist in a vacuum, of course, and the expectations of participants in the real economy matter as well. The University of Michigan’s consumer survey indicates that households’ expectations accord with financial markets’ (Chart 4): inflation will be uncomfortably high over the next year but an afterthought five years from now. Whether the phenomenon is called adaptive expectations or recency bias, everyone’s – investors’, consumers’, businesses’, and economists’ (Chart 5) – expectations of the future are colored by the recent past. It is not a stretch to envision consumer prices rising by more than 4% in 2022 after having watched them surge since March, but apparently economic participants will need to see them remain elevated for a longer stretch before they can picture inflation enduring for two or three years, much less five to ten years. Chart 45% Now, But Only 3% Later Chart 5Reliably Anchoring To The Recent Past What Markets Expect: Fed Policy Chart 6Faster, Yes; Farther, No If inflation isn’t expected to persist at an elevated rate for an extended period, there’s no reason to expect that the Fed will aggressively tighten monetary policy. Higher-than-expected inflation readings have led money markets to bring their first rate hike ETA (the liftoff date) forward to next July, and to price in two rate hikes in the second half of next year (Chart 6, top panel). They continue to expect that the Fed will conclude its tightening cycle once the fed funds rate is around 2% (the terminal rate). They also expect that the Fed will take its time getting to that terminal rate, hiking by no more than 75 basis points (“bps”) in a single year (Chart 6, bottom two panels), roughly in line with the 100-bps annual pace of 2017 and 2018. The Fed concurs. As per the latest Summary of Economic Projections (SEP), released after the September FOMC meeting, the 18 board members and regional presidents casting votes expect the FOMC to take its time hiking rates. With exactly half of the voters calling for no rate hikes next year, the median and mean expectations were for one-half and two-thirds of a 25-bps rate hike in 2022, respectively (Chart 7A). By the end of 2023, the median and mean SEP voter expects a cumulative 3.5 and 3.1 25-bps rate hikes, respectively (Chart 7B). By the end of 2024, median and mean expectations are for a cumulative 6.5 and 6.1 25-bps rate hikes, respectively (Chart 7C). ​​​​​​ ​​​​​​​​​​​ Table 1Same Terminal Rate, Different Liftoff Date Conditions have changed since late-September upon the release of September and October inflation data, though Chair Powell didn’t give any ground in his press conference following the November 3rd meeting. Rounding the expectations at each year-end period as of the September 22nd meeting, the median SEP voter expected zero or one rate hike in 2022, three in 2023 and three in 2024, pushing the top end of the fed funds rate range to 2% as of the end of 2024. Market expectations have moved since the last SEP, with the overnight index swap curve going from zero rate hikes in the next twelve months to two, and from two rate hikes in the next 24 months to five, but financial markets and the Fed remain on the same page (Table 1). A Kinder, Gentler Fed Emboldened by the experience of the last expansion, in which worrisome inflation did not materialize despite a zero fed funds rate and 50-year lows in unemployment, the Fed has embarked on a course quite different from the one the late Paul Volcker might have charted. Nagged by persistently low post-crisis inflation, the FOMC has decided that pursuing an average inflation target that makes up for previous shortfalls will best allow it to meet its price stability mandate. Letting undershoot bygones be bygones paved the way for inflation expectations to slide, constraining its ability to stimulate the economy at the zero bound. To re-anchor expectations in its preferred 2.3-2.5% range, and give a zero fed funds rate more zip, the FOMC must convince markets that it will occasionally let inflation run hot. A more aggressive pursuit of its full employment mandate, as outlined in the August 2020 revisions to the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy, should also help nudge expectations upward. Per the revisions commentary on the Fed’s website, “The previous expansion demonstrated that a strong labor market can be sustained without inducing an unwanted increase in inflation. To the contrary, when unemployment fell to levels that were previously thought to be unsustainable, the labor market proved remarkably adaptable, bringing many benefits to families and communities that all too often had been left behind. Accordingly, the new Statement … only … [pledges to address] ‘shortfalls of employment from its maximum level’ rather than the [previous] ‘deviations from its maximum level’[.] This change signals that high employment, in the absence of unwanted increases in inflation or the emergence of other risks that could impede the attainment of the Committee’s goals, will not by itself be a cause for policy concern.”2 The Fly In The Ointment Chart 8Wall Street And Main Street While we acknowledge that the September 22nd SEP may be somewhat out of date as a guide to the board members’ and regional presidents’ fed funds rate expectations, the easier stance outlined in the revised monetary policy strategy statement remains very much in effect. The upshot, from our perspective, is that the FOMC intends to be behind the inflation curve in the coming rate-hiking cycle. If inflation remains contained after lingering pandemic dislocations are resolved, the behind-the-curve takeaway will not be all that impactful for investors. After all, those who positioned for dollar debasement and runaway inflation when the Bernanke Fed introduced QE and ZIRP were clobbered by investors who loaded up on risk assets and blithely rode easy money tailwinds higher. There is a critical difference this time, however, beyond the increasing magnitude of the Fed’s accumulated asset purchases. Pandemic fiscal stimulus has dwarfed the comparatively meager fiscal response to the global financial crisis. And going forward, the Biden administration’s spate of ambitious spending proposals contrasts sharply with the Obama administration’s deficit reduction focus. The post-crisis era has served as a natural experiment on the effects of unprecedented monetary accommodation on economic activity and consumer price inflation. Asset prices surged, buoyed by a negative real fed funds rate and a ballooning Fed balance sheet (Chart 8, top panel), but the rate of growth in consumption (Chart 8, bottom panel) was unchanged. Although household net worth gains lead consumption growth, the vast majority of financial assets are held by households with a low marginal propensity to consume. Asset price inflation doesn’t necessarily lead to consumer price inflation because it doesn’t necessarily have an observable impact on aggregate demand. Fiscal stimulus is different, however. The stimulus packages created to counter the economic effects of COVID-19 put money directly in the hands of households with high marginal propensities to consume. They have been consuming avidly since emerging from their spring 2020 lockdowns (Chart 9) and we expect that they will continue to do so until they’ve run down at least one half of their $2.3 trillion of excess pandemic savings. Rising wages may additionally promote demand, as will the baby boomers’ shift into their peak consumption years, along with the massive investment required to meet green energy goals. Chart 9Consumers Have Momentum (And The Savings And Borrowing Capacity To Sustain It) Demand was sluggish for an entire decade following the GFC, but it appears as if it will be quite robust for a while after the pandemic. We believe that aggregate demand is on a course to exceed aggregate supply after reopening supply chain issues are resolved. At that point, the transitory inflation view will no longer be credible, and the Fed may find itself having to play catch up. When it does, it will have to hike rates more and faster than financial markets expect. Once the Fed has shifted into fast and furious mode, or markets develop a widespread conviction that it will, the bull markets in risk assets will end and the expansion might, too. In the meantime, setting investment strategy will depend on how long it takes for the inflation inflection point to arrive. We do not yet think the inflection point is in sight and therefore continue to recommend that investors with a twelve-month timeframe overweight equities and credit in multi-asset portfolios. We remain on the alert, however, and will shift our view if events move faster than we currently expect. We would rather leave some upside on the table than stay at the party too long.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      Off-the-run Treasury maturities do not trade all that well, and TIPS other than 1-, 2-, 5- and 10-year maturities are even less liquid. The TIPS inflation expectations curve (Chart 2) is therefore less reliable than the CPI swaps curve (Chart 3) at individual points, but it confirms the broad direction of investors’ inflation expectations. 2     Question 6, How has the review altered how the Federal Reserve will pursue its maximum employment objective? Accessed November 22, 2021. Emphasis added. Federal Reserve Board - Q&As.  

Highlights There are a few consistencies with the dollar breakout. Global growth is peaking and the risk of a significant slowdown early next year has risen. As a momentum currency, further gains in the DXY remain very high in the near term. We are shifting our near-term target to 98 (previously 95). That said, the dollar is now close to pricing a global recession, which seems improbable given easy monetary settings and ample fiscal stimulus. High inflation is not a US-centric phenomenon but a global problem. This means that monetary policy in the US cannot sustainably diverge from other central banks. Correspondingly, low US TIPS yields do not confirm the breakout in the dollar. Even if the US 10-year Treasury yield rises towards 2.5%, real interest rates will remain very low compared to history and other G10 economies. While global growth will slow next year, we expect that it will remain robust. And if it rotates from the US to other countries, the dollar will have a very sharp reversal. Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Feature Chart I-1The Dollar Diverges From Real Rates After spending most of this year range bound between 89 and 94, the DXY index has broken out. The narrative has been centered around rising US inflation, which will trigger much faster interest rate increases from the Fed. This is consistent with recent economic data, where US inflation has indeed blown out, and is also rising at the fastest pace among G10 countries. What has been inconsistent is that US TIPS yields remain very low, and have diverged from the broad dollar trend (Chart I-1). One of the key structural drivers of currencies is real interest rate differentials. If the Fed does move ahead of the inflation curve and aggressively hikes interest rates, then US TIPS yields will rise and catch up with the dollar. Otherwise, the recent rise in the greenback could represent a capitulation phase that will quickly reverse should the inflationary mania subside. Consistencies With The Dollar Rise The market is now pricing in that the Fed will raise interest rates much faster, compared to earlier this year. According to the overnight index swap (OIS) curve, the Fed is now expected to lift rates at least twice by December 2022, compared to earlier this year (Chart I-2). Meanwhile, market pricing is even more aggressive when looking at the December 2022 Eurodollar contract, relative to either the Euribor contract (European equivalent) or Tibor (Japanese equivalent). The market suggests that compared to earlier this year, a 63bps spread difference is now warranted between US and European interest rates, while an 80bps difference is appropriate vis-à-vis Japanese rates. This shift perfectly explains the move in the dollar over the last few weeks (Chart I-3). Chart I-2Markets Now Expect A More Hawkish Fed Chart I-3A Key Driver Of The Dollar Rally These market moves have been consistent with economic developments. Upside economic surprises in the US have dominated other G10 economies and supported the dollar (Chart I-4). The slowdown in China has been another hiccup in the global growth story. While global export growth has remained relatively resilient, the narrative is that the slowdown in Chinese demand is metastasizing into a genuine slump that will impact commodity import demand and hurt procyclical currencies liked the AUD (Chart I-5). Chart I-4Positive Economic Surprises Have Supported A Strong USD Chart I-5A Slowing China Has Hurt Currencies Like The AUD The slowdown is not unique to China. With new Covid-19 infections surging in various European countries, ex-US economic data is likely to remain underwhelming early next year. Within this context, the US economy remains relatively immune. Exports explain only 10% of US GDP. The IMF projects that the US is one of the first countries to close its output gap (Chart I-6). This will support a tighter monetary stance in the US, compared to other G10 countries. Contradictions With The Dollar Rally There are a few contradictions with the dollar rally. First, the Fed is already lagging the US inflation curve. Various DM and EM central banks have calibrated monetary policy higher in response to rising inflation (Chart I-7). While the Fed might accelerate the pace of tapering asset purchases, other central banks in developed economies have already ended QE and are raising rates. At some point, relative monetary policies would matter for currencies, as has historically been the case. Since the start of the year, market pricing for higher rates according to the OIS curve has been lifted for most G10 countries (Table 1). Yet the dollar has rallied, while other currencies have collapsed (Chart I-8). Chart I-7Many Central Banks Are Already Hiking Interest Rates Chart I-8Will The Fed Hike As Much As Is Priced By The Dollar? Second, part of that rally has been driven by speculative inflows, and not by underlying economic fundamentals. Net speculative positions in the US dollar are near levels that have usually signaled that the trade is becoming much crowded (Chart I-9). As we highlighted in Chart 1, this has occurred amidst very low nominal and real interest rates. But more importantly, as a reserve currency, the dollar enjoys the priviledge of being the safe-haven asset of choice. It is quite plausible that one of the key drivers of the rally has also been hedging by fund managers for an equity market correction (Chart I-10). Chart I-9Speculators Are Nearing Exhaustion ##br##Levels Chart I-10Long Dollar Is Being Used To Hedge Bullish Equity Bets Third, inflation could indeed prove to be transitory. Our sister publication, the Commodity & Energy Strategy, suggests that metals and oil prices will remain well bid in the near term. Inflation however is about rates of change. Natural gas prices rose 100% this year while oil prices rose 60%. Market expectations are that these prices will roll over (Chart I-11). The Baltic Dry Index, a proxy for shipping costs and supply bottlenecks, initially rose 300% and is now down 53% from its peak. A middle ground where prices remain well bid but do not generate the same inflationary impulse next year seems most plausible. This will ease all market expectations for central bank hawkishness, but could sound the death knell for the dollar that has quickly moved to price in the current market narrative. Chart I-11Some' Inflation Will Be Transitory Fourth, a strong US dollar hurts US growth. According to the Fed’s own estimates, a 10% rise in the dollar reduces US growth by 0.5% in the subsequent four quarters and 1.2% over two years. Meanwhile, a strong US dollar will certainly alleviate pressure on the Fed to fight inflation. A Counterpoint View To The Market Narrative Covid-19 will be with us for a while. As such, the volatility of growth forecasts around infection waves will subside. The remarkable thing is that despite fears of a global growth slowdown, there is a pretty robust expectation that the US will fare poorly relative to other developed markets in terms of growth next year. Countries such as Canada, New Zealand, the UK, and Japan are seeing a bottoming in growth momentum relative to the US (Chart I-12). For some, this is occurring at the same time as their local central banks are becoming more orthodox about monetary policy. As we have argued earlier, this is clear real-time evidence that the Fed will lag the inflation curve. Chart I-12AA Global Growth Rebound Outside The US Chart I-12BA Global Growth Rebound Outside The US One key signpost is China. It has tightened policy amidst very low inflation, and the traditional relationship between real rates and the RMB is working like a charm as the currency appreciates in trade-weighted terms. In a nutshell, currency markets tend to reconverge with real interest rate differentials over time. This will eventually be the case with the dollar (Chart I-13). Chart I-13Real Interest Rates Eventually Matter For Currencies Finally, China might marginally ease policy to sustain growth. In our view, China could stand pat since nominal bond yields are falling and exports are robust suggesting overall financing conditions are not a problem. But if this is a primate cause for fuelling long dollar bets, that will eventually hurt EM demand, China could also shift. This will be bullish for the dollar in the near term (it will require a riot point for China to shift), but bearish the dollar over a cyclical investment horizon, as commodity economies bottom. Investment Strategy Chart I-14Current Dollar Strength Is Pricing In A Manufacturing Recession In the current environment, the DXY could hit 98. This will be consistent with a blowout in our capitulation index, as well an exhaustion of dollar bulls. That said, the dollar is now close to pricing a global manufacturing recession, which seems improbable given easy monetary settings and ample fiscal stimulus in most DM economies (Chart I-14). Our strategy is to stick with trades at the crosses rather than outright dollar bets. These include long AUD/NZD, long CHF/NZD, long EUR/GBP and long a petrocurrency basket versus the euro. Once the majority of our technical indicators start to flag a reversal, we would be sellers of the DXY and buyers of EUR/USD. Finally, our agnostic trading model continues to suggest short dollar positions (Chart I-15). Admittedly, it is the valuation component driving the calibration, rather than sentiment or appreciation for the investment shift in the macro narrative. In our portfolio, we will sit on the sidelines until most of our intermediate-term indicators stage a reversal. Chart I-15AOur Model Is Short The Dollar, But Stand Aside For Now Chart I-15BOur Model Is Short The Dollar, But Stand Aside For Now Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary