There’s no longer any point in using words like “disconnected” to describe the relationship between nominal long-end yields and the incoming inflation data.
We’re now so far afield that such adjectives are empty.
That’s one message from the latest by Deutsche Bank’s Aleksandar Kocic. “The departure of rates from inflation has become so extreme that it is meaningless to talk about dislocations anymore,” he said. “There is little doubt that this is an entirely different game now.”
The figure (below, from Kocic) illustrates the point. Rates, he observed, “have opened up a 300bps deficit relative to where they should have been had things been anywhere near normal.”
In some ways, this underscores Jerome Powell’s contention that we’re simply in uncharted territory and thus prone to drawing spurious conclusions if we’re not “patient.” But unfortunately for the Fed, the general consensus right now is that the persistence of the flattener amid hot inflation prints is evidence of a policy mistake in the making.
In that context, this is a lose-lose for the Fed. Not pivoting hawkish in the face of accelerating inflation is derided as irresponsible. But when the Fed delivered on the hawkish pivot demanded by so many commentators, economists and pundits, the FOMC inadvertently raised the specter of a policy mistake in the eyes of market participants.
Commenting on the original CPI overshoot (i.e., from April), Kocic wrote that the “uneasy tension triggered all kinds of afterthoughts of an inevitable future bond market crash only to be topped by yet another record dislocation in May.” Last week, yields fell again, even as inflation surged a third month.
Lampoon the “transitory” narrative as you will, but the fact is, the data remains hopelessly distorted. The figure (below) shows the spread between the Cleveland Fed’s 16% trimmed mean gauge and YoY core CPI.
That’s one loose proxy for the scope of the pandemic effect. “Divergence between the two is a relatively recent occurrence,” Kocic said, noting that the spread “has never been this wide.”
As alluded to above (and discussed Friday in “The Bull Case Is Ambiguity“), the inconclusiveness inherent in the situation gives the Fed plausible deniability, even as it lets market participants write their own script (or choose their own adventure, as I’m fond of putting it). Kocic wrote that,
This ambiguity in interpreting inflation data puts the Fed in a positive convexity position allowing considerable flexibility in interpreting the significance of the numbers and adjustments of monetary policy accordingly without any damage to its credibility. At the same time, it allows the market to take a range of views on both inflation and Fed’s interpretation.
You might be inclined to assert that each passing inflation report erode’s the Fed’s credibility, but such criticism will generally fail to “stick” until it becomes clear that price pressures have persisted beyond some reasonable timeframe over which one might expect various bottlenecks and supply chain disruptions to get sorted out.
Kocic went on to say that the real divergence of “opinion” between the market and the Fed shows up in estimates of r*, with the market’s estimate considerably lower than policymakers’. “The current Fed median estimate is around +0.5%, which is about 250-300bps above the current real short rate, around -2.5%,” he said, which suggests any effort to “meaningfully” hike rates could end up being unduly restrictive.
As for the curve, the story is simple enough. I’ve been over it so many times now, I imagine regular readers can parrot the narrative from memory. As Kocic put it, the curve is “taking the transitory story and overlaying it with the opinion on the Fed’s preparedness to act preemptively (its departure from dovish AIT).” The result is that the curve is generally in agreement with the notion that rate hikes could ultimately be self-defeating, as Kocic put it.
But stocks haven’t yet come fully around to any of this, and therein lies the potential risk. To be sure, equities aren’t ignoring rates, per se. Reflation expressions have come off, while trades tethered to duration and bull-flattening have outperformed. Small-caps lagged big-cap tech in four of the last five weeks, for example (figure below).
That said, as an asset class, equities are still relatively “agnostic” (Kocic’s word) amid the inflation kerfuffle. It’s difficult to argue that stocks, which many insist are priced to perfection notwithstanding “TINA,” are in a position to absorb restrictive Fed policy.
“If Fed hikes were to become restrictive, risk assets would sell off and the curve bear flatten or twist,” Kocic went on to say, before noting that although the implied correlations market “has already begun to price the mode of higher rates and lower equities, flattening accompanied by lower equities is still not priced in.”
That said, when it comes to the sometimes shrill, discordant tone of the inflation/policy clash, he wrote that when it’s all said and done, we could be left staring at “an unremarkable resolution, gradually making excitement and panic the main collateral damage.”