Inflation forecasts: for the Fed, these are just empty words

This article was written exclusively for

  • The Fed’s speech last week aimed to test the market’s response to the test ball at 75 basis points.
  • Markets have unequivocally rejected the Fed’s investigation into this
  • The hawks’ conversation is easy and unimportant. Actions will be more balanced.

In the foggy corners of bond market history, in the early 1990s, monetary policy was still largely in the shadows. When the Federal Reserve came together to determine policy, there was no announcement after the meeting or, God forbid, a press conference about what it had decided. The change in policy was announced by phone and response.

Assume that the rate of federal funds overnight is 5%, and the market expects rates to rise. Interbank traders tied the market at 5.25% and waited to see how the Fed’s open markets department would react during the scheduled intervention time of 11:30 am. If the service intervened with “systemic repo”, it meant that he considered the rate of 5.25% too high and thus indicated to the market that no reinforcement had been introduced. If it was a “double sale”, it meant that the rate of 5.25% was too low, and the Fed raised the rate to at least 5.50%. (The message is: we will have to wait until tomorrow when we repeat the experiment again to find out 5.50% or 5.75%). If the Bureau did not respond, it meant that 5.25% were satisfied.

Today, the challenge and the answer are changing places: the Fed is calling, the market is answering.

Earlier this week, the market speculated that the FOMC at a meeting on May 4 plans to increase overnight rates by 50 basis points, which was taken into account. Then, last Monday, Fed President St. Louis Bullard briefly mentioned that he did not rule out raising interest rates by 75 basis points at some point.

On Tuesday, interest rates rose by 13 basis points to 2.92%. It will be recalled that last September 5-year treasury bonds were at the level of 0.75%! After a slight recovery on Wednesday, yields exceeded 3% on Thursday and reached almost 3.05% on Friday. Bullard is considered a hawk. But on Thursday, Fed Chairman Powell made his strongest comments, although he did not specifically mention 75 bps.

The shares were expected to reach a two-week high that morning, but they were notified. Between the beginning of the day on Thursday and closing on Friday, the price fell by 5.4% in volume growth (see chart, Bloomberg source). A clear message? “We had a good 50 bits. But step back from the discussion of 75 bps. “

FOMC found a sore spot. Hawk’s conversations were their call, and the market’s reaction was crystal clear. So we can be pretty sure the Fed won’t raise its rate by 75 basis points on May 4, and if the stock market doesn’t find a bottom in the next few days, you can be sure that the Fed’s speakers will say reassuring words.

SPX 24 years

A little back …

But these are just words. Yes, now everyone agrees that the monetary response to COVID was wrong, that the Fed has gone too far, and that we now need to fight inflation. Hoysington, a store legend who believed that risk was long-term deflation, not inflation, even joined the campaign and made an interesting point in a letter this week: the weak helped tens of millions, but high inflation hurt 170 million. Inflation must be fought . But … what if the stock market falls by 10% and hundreds of millions of people lose money?

Conversation is a free option. Just like I can talk about my rugby skills in a water cooler, there’s really nothing wrong with talking until it’s time to go out on the field. In this case, the language is cheap (which is good, because nothing else is cheap). The truth is not in the conversations, but in the ability to get up after I was first undressed by a 250-pound pole.

Domingue of Ortega

Domingue of Ortega

Image: Barnaby Conrad via Britannica

Spanish bullfighter Domingo Ortega best described the difference between those who speak and those who speak:

“Critics of bullfighting line up and fill a huge area, but only one knows, and that’s the one who fights the bull.”

And how relevant is this link, after all? The Federal Reserve is gradually killing the bull, trying not to get a puncture. Ortega also said that when the matador was injured, the bull was never guilty. The head of the Federal Reserve knows that if the stock market collapses, it will be his fault.

The problem is that these things cannot coexist. Inflation will not be curbed by a gradual increase, which will lead to an overnight rate of only 2.5%. High inflation, if left unchecked, destroys real returns on all classes of financial assets. High interest rates, especially in combination with high energy prices, will lead to a recession. And high market ratios cannot survive high discount rates, potential recessions and rapid changes in prospects for both.

Last week, markets began to see a mismatch and address the fact that the forward interest rate curve is not in line with the forward inflation curve and the forward capital curve.

Break-even rate for 10 years in the US W1

Break-even rate for 10 years in the US W1

Last week, the break-even point of inflation reached new highs in ten years (since the release of TIPS in 1997) – see chart above. If you believe the stock market, you should buy bonds. If you trust the bond market, then you need to sell stocks.

The Fed is not meeting this week; this is next week. But some of this week’s data will be useful for these discussions. I have to reiterate that I think the market has given the Fed the green light to raise rates by 50 basis points, and with the exception of significant changes this week, this is a likely outcome.

The debate revolves around how quickly the Committee would like to bring bets to what it considers “neutral”, although hardly anyone else does. The S&P Corelogic index on Tuesday (forecast for 20 cities: + 1.5%, 19.20% yoy) is an important indicator, although it is moving slowly, and therefore should not affect the short-term decision of the Fed.

The report for the 1st quarter on Thursday will trigger many searches for the word “stagflation” with an expected growth of only 1.0% year on year, but + 5.6% for. The figures will correspond to the increase in the velocity of money, although we do not yet have the March figures M2, so we can not be sure. On Friday we will receive the only “new” information on inflation, the labor cost index is expected at + 1.1% qoq – another new maximum of 1.5 generations for the same period last year.

In addition to data, we will pay special attention to news from China. It is hard to imagine that the country will be able to remain in quarantine – let alone – for as long as the rest of the world takes off its masks, but the longer it does so, the less aggressive the Fed’s actions will be over the next six months. probably. I still believe that the short end of the Treasury curve rejects overly aggressive action by the Fed, the long end does not sufficiently ignore the actual change in inflation, and the stock market overrides another incredibly optimistic outcome.

Michael Ashton, sometimes referred to as the “Inflation Guy,” is the managing director of Enduring Investments, LLC. He is a pioneer of inflation markets, specializing in protecting wealth from the pressures of economic inflation, as he describes in his podcast Cents and Sensibility.

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