When BofA asked the 350 panelists who participated in the November edition of the bank’s Global Fund Manager survey to identify the “#1 driver of asset markets” in 2022, there was little in the way of equivocation.
The participants, who together control $1.2 trillion in AUM, overwhelming chose “Inflation and the Fed.”
There were five alternatives. “Reopening and profits” was a distant second (figure below) with China, geopolitics and the US midterms all barely registering compared to inflation and US monetary policy.
Note that BofA’s decision to combine inflation and the Fed into a single choice was apt. While everyday people (“Main Street,” as it were) may be concerned about the impact of rising prices on their standard of living, market participants are more concerned with the implications for monetary policy.
As discussed here on Wednesday, history offers little in the way of guidance when it comes to assessing the likely evolution of inflation in the US. That lack of a context — the absence of a framework to consult or a historical lens through which to peer — is manifesting in an obsession with the front-end, while long rates meander.
Thursday was indicative. “A cursory glance at the screens would suggest that Thursday’s trading session in Treasurys was uneventful and, to some extent, that is an apt characterization,” BMO’s Ian Lyngen and Ben Jeffery wrote, adding that “the manner in which the FOMC chooses to address the recent resurgence of inflation is anything but evident and there are compelling arguments for policymakers to err on the side of hawkishness based solely on the magnitude of the consumer price gains already realized in the US – to say nothing of the potential for forward inflationary gains.”
The “divergence of opinions,” as they put it, regarding where longer rates go next is as much about the impossibility of forecasting inflation as it is about anything else. It’s simply impossible to have an informed opinion. Upon what would such an opinion be based? Folks keep citing the 70s. There are similarities, sure. But it’s hardly a perfect analogue.
Instead, market participants have defaulted to betting on policy, hence the lively front end. It’s about the trajectory of inflation and growth, but specifically about the trajectory of inflation and growth “seen through their interplay with the Fed’s reaction function,” as Deutsche Bank’s Aleksandar Kocic put it.
In a new note, Kocic explicitly referenced the notion that the economy (“the macro”) may now be irrelevant. Markets were already predisposed to caring solely about monetary policy. These are, after all, administered markets.
Now that the macro is completely ambiguous, the market has simply detached itself altogether as evidenced by the scatterplot (below) which I also featured in a separate article calling attention to the “horizontal straight line” illustrated by the red squares.
Kocic — always brilliant — wrote that “there is nothing more predictable than a horizontal straight line and, yet, it is creating considerable turbulence (at least in the bond market, for now) and tensions across different market sectors.”
What you see in the scatter suggests “market variables have achieved their autonomy from the economic fundamentals and their disagreement can no longer be interpreted as a temporary dislocation that is likely to converge, but emergence of an altogether new framework.”
He alluded to this previously. Last month, Kocic wrote that “the mechanisms that have been governing the markets [since the financial crisis] have largely lost any external points of reference, can now be evaluated only in their own terms, account for all market realities and cannot be exchanged for anything else.”
The path of inflation is mostly inaccessible. Nobody knows if it’s transitory, permanent, semi-permanent, quasi-transitory, fleeting, enduring, ephemeral, abiding or something else. “What remains accessible, at least to some extent, are the probabilities associated with central banks’ actions,” Kocic said Thursday. “As a consequence, the market’s focus remains on the near-term monetary policy and the front end of the curve.”
This brings us full circle. When BofA listed “Inflation and the Fed” as one of the alternatives on the list of possible asset drivers for 2022, they certainly meant to capture the interaction between the two in a single choice for survey panelists. What they probably didn’t consider, though, is that for market participants, inflation on its own isn’t all that relevant. If it were, 10-year yields would be up around 7.5%.
So, “Inflation and the Fed” is indeed what matters. Because it’s only through their impact on the Fed’s reaction function (and thereby the price of money) that economic fundamentals have any relevance at all for market variables anymore.
So, 10-15% cpi with fresh record low real yields would do wonders for multiples…
Is there a point where it’s too perverse to countenance?
The Inflation abides.
You really know how to dial right in to the heart of the matter. I appreciate that you write not only about how things “should” work, but also about how things actually work.
It is up to us to decide what is what!
How about strong economy with moderating inflation and slow normalization of rates? Oil is rolling over; supply chain disruptions in most categories to follow. The tail risk would be the extremist far-right GOP not be willing to acknowledge good news.
H-Man, Milton Freidman analogized inflation to alcholism, it starts off good with pleasant effects but when it ends, it gets really ugly.
The Fed could squash inflation in a heartbeat. One .50 increase in Fed Funds rate accompanied by more increases would pretty much do it.
It always surprises me how bad so-called experts and CEOs are at predicting the future. They know nothing.
I think that part of what we’re seeing in the economy, in the big picture, is a failure of government. There was a meta-stable period from about 1945 to about 2007 when the government of the US more or less “worked,” when there was such a thing as anti-trust, there was bipartisan guard-railing of the economy, and many systems that were not written in law nonetheless functioned according to conventions and custom. The relationship between interest rates, employment, inflation, and asset valuations was somewhat discernible, and behaved more or less according to a set of reversible functions–in large part because there was a functioning government that could adjust policy when needed. For a variety of reasons, we’re not in that regime anymore. Social media and misinformation have escaped the guardrails. Conventions of behavior in Congress are gone. Election results aren’t respected. Policy decisions are feebly channeled through the few mechanisms that are still functioning, but the result is ineffectual–we are like the mighty Bismarck, sailing in a wide circle, our rudder jammed. Laminar flow has given way to turbulence. I don’t know what will reset the system, but I’m afraid of some of the ways this might happen.
I think your timeframe for the stable period should have ended in the 60’s. Corruption has been growing within all ranks of government since that time. Vietnam was an act of corruption. Nixon’s white house was the most corrupt until Trump’s came into town. Corruption is now so widespread that we ignore and dismiss obvious signs of it as nothing of concern. Money controls DC, DC’s only objective now is to keep the money happy.
60’s followed by an acceleration of the gov’t dysfunction after 1992 election … then US gov’t dysfunction on steroids after 2016 election, and here we are…
My personal subjective view is the risk and uncertainty is at least as much to social order as it is to the markets. Could we continue to have a bull market in equities while having social and political chaos? I think we could…..I was not happy that the fed bought junk bonds ig bonds and cemented the complete takeover of funding for the martgage markets. I frequently ask myself where this stuff would be trading without the fed.