A Sticky Situation

“Peak inflation” may be upon us (in the US, anyway), but the relief for markets may prove transitory. And yes, that policy joke was obviously intentional.

Increasingly, concerns around unanchored longer-term expectations and the prospect of a nightmarish, emerging market-style price spiral, are giving way to a less apocalyptic, but still highly vexing, narrative centered on the notion that elevated inflation will be a fixture of developed economies for the foreseeable future.

That’d be uncomfortable enough on its own, but the potential for such an outcome to prove pernicious for markets is amplified by the juxtaposition with a decade of negligible real economy inflation and decades (plural) of moderating macro volatility. Colloquially: We’re not used to this sort of thing, and that probably means we aren’t prepared for it either.

The figures (below) illustrate the point perfectly. The chart on the left shows fund managers polled by BofA in August overwhelmingly expected lower inflation over the next 12 months, prompting a nascent turn in expectations for higher policy rates.

The chart on the right shows the same fund managers (or some of them, anyway) are more concerned about lingering inflation than ever.

Market commentary reflects that conjuncture. “My underlying thesis since last year has been that we’re in an unprecedented inflation-regime shift,” former Lehman trader Mark Cudmore wrote, in a recent column for Bloomberg. “Such levels of inflation have been seen before (more than 40 years ago), but never in such a direct and speedy transition from decades of low inflation,” he added. “So the market will continuously underestimate and underappreciate the scale of the problem.”

That, in turn, opens the door to ongoing disappointment in 2023, once some of the energy/commodity premium comes out of the headline inflation prints, laying bare how deeply-rooted the issue really is. “Inflation is a priority, but recent energy relief does not capture the underlying picture,” SocGen’s Stephen Gallagher said this week. The bank expects “a rapid and material pullback from 9% inflation,” predicated mostly on energy prices, which Gallagher reminded investors are “difficult to predict.” That was a gentle way of suggesting that even the widely held belief that energy prices (sans Europe) will retrace isn’t a foregone conclusion.

“August inflation data are very likely to show receding price trends due to energy [but] the problem is rents and other ‘sticky’ price trends, with rent increases running at a 5.5% pace,” Gallagher went on to write. “These underlying price trends pose major challenges for achieving a 3% core inflation trend, let alone the desired 2% goal.”

That’s where the proverbial rubber meets the road for investors and traders. Generally speaking, the well-to-do (which includes most, if not all, investors) wouldn’t be troubled by 3% core inflation. But policymakers would. And their response will partially dictate the direction of markets.

Cudmore reiterated as much. “I have regularly argued that front-end yields need to go significantly higher still,” he said. “Importantly, there’s no risk of a Fed put and it doesn’t matter when inflation peaks, but how sticky it is.”

Suffice to say this is a pretty sticky situation (figure above).

Nomura’s Charlie McElligott has been particularly adamant on this point. “Looking out into the medium-term, my ongoing concern is about Q1 next year, when the market [may] see that yes, we are off peak inflation for a litany of reasons, but we are still stuck at an uncomfortably high 4-5%, far from target, but occurring simultaneously with the [achievement] of the terminal rate in March or April, risking a ‘now what?!’ moment,” he wrote.

I can answer that “now what?” even if I can’t answer myriad others. A Fed keen to avoid a 70s rerun would likely keep policy restrictive and perhaps push the envelope with incremental 25bps hikes (say, at every other meeting). At the least, that prospect (and, perhaps, a predisposition on the part of nervous markets to assign more weight to the “aggressive” dots on the plot and discount the dovish markers as wishful thinking in a sticky inflation regime) could entail a repricing both in STIRs and simply at the front-end of the Treasury curve, which would act as a de facto tightening for markets.

I’d contend this is an H1 2023 story. For Cudmore, it’s germane in the here and now. “Jackson Hole is very likely to see Jerome Powell quash the ‘delusional’ idea of a 2023 Fed pivot by focusing very much on the threat from entrenched inflation expectations,” he wrote.

Somewhat ironically, a far-fetched scenario in which the Fed begrudgingly acquiesces to the intractability of above-target inflation at least for the foreseeable future could be even worse for markets than a quixotic Fed that insists 2% is achievable. On many interpretations, a disorderly bear steepener is still the most dangerous outcome of them all.