‘Large Inflation Downshift’ Coming, JPMorgan Says. But…

“The baseline remains,” JPMorgan strategists wrote Monday, summarizing the bank’s views across assets and markets.

At least as it relates to asset allocation, that baseline became marginally less constructive for risk last week, when the bank trimmed their equity Overweight and their bond Underweight, while remaining Overweight stocks and Underweight bonds overall. They cited “increasing risks around central banks making a hawkish policy error and geopolitics,” factors mentioned by Marko Kolanovic late last month in a lament for what he described as “throwing rocks in glass houses” on the part of policymakers.

From an economic perspective, JPMorgan’s baseline still revolves around the prospect of what the bank on Monday described as “a large inflation downshift led by softer goods prices.” That outcome is “on its way,” and when taken in conjunction with “recent Fedspeak hinting at some unease with more big rate rises to fight inflation,” the read-through from JPMorgan’s perspective is a likely step down in the pace of rate hikes following the November meeting, at which a 75bps move is all but assured. The bank sees the Fed pausing once rates hit 4.75% early next year.

Of course, caution is warranted. And JPMorgan didn’t dance around that. Specifically, no one is completely sure when leading indicators of inflation will manifest in the official data, upon which the Fed bases its decision making. This debate played out in the public sphere last week courtesy of a somewhat contentious exchange between Paul Krugman and Larry Summers.

JPMorgan noted that when it comes to the Manheim Used Car Index, for example, there’s a lag between movements in wholesale and retail prices (figure on the left, below).

As for shelter, the bank noted that “it takes time for the rents on new leases to pass through to the official measures as the existing stock of leases gradually incorporates the flow of new leases.” That’s illustrated (roughly) by the figure on the right (above).

The dynamics in the rental market are, of course, a reflection of various distortions and points of friction in US housing, where mortgage rates are more than four full percentage points higher versus the lows hit early last year.

“The higher costs of rent have reflected potential homebuyers forced to rent after being priced out by rising mortgage rates, whereas rents rolling over recently reflects discouraged homesellers unable to sell, putting up their properties for rent,” JPMorgan’s strategists said.

At the same time, wage growth, while still insufficient to overtake the 12-month pace of headline inflation, is nevertheless very robust in nominal terms, and there are reasons to believe labor’s resurrection as an economic actor with at least some clout won’t prove entirely fleeting. In other words: It’s not obvious that upward pressure on wages will simply disappear altogether even in the face of fewer job openings and a slower pace of hiring.

If wage growth remains robust, that could “fuel persistence in currently elevated core services inflation,” JPMorgan cautioned, noting that stubbornly high inflation in 2022 has led investors to expect higher policy rates for longer. The associated risk is that eventually, the extreme disconnect between long-end US yields and inflation outcomes (figure below) resolves with yields moving higher, instead of inflation moving lower.

That risk partly informs JPMorgan’s bearish duration bent in their model portfolio, despite the cut to the bond Underweight mentioned here at the outset.

To be clear, none of the above should be interpreted as a “call” or any sort of definitive recap of the bank’s view on US rates. Again: The excerpts are from a weekly summary of JPMorgan’s cross-asset views. That’s just what it sounds like — a brief, concise summary. Nothing more, nothing less.

So, why highlight it? Well, I’ll tell you. Notwithstanding the very plausible contention that a weaker US economy, falling inflation expectations and/or a haven bid for duration catalyzed by additional macro or geopolitical shocks, could easily spark a duration rally with the potential to become self-fulling given lopsided positioning, I’ve repeatedly mentioned the tail risk associated with an unanchored long-end.

However far-fetched, you can’t completely rule out a scenario wherein inflation remains stubborn (e.g., due to persistently elevated wage growth which allows corporates to keep raising prices to consumers) and a premature Fed pause leads markets to question the Committee’s commitment. In such a scenario, the fabled vigilantes who, with an ironic assist from the Bank of England, toppled Liz Truss this month, could be emboldened to force US yields up to levels that are more consistent with their historical relationship with to inflation.

Such efforts would probably fail. The Fed isn’t the BoE after all, and unlike Andrew Bailey, who some suggested was intent on letting the market decide the fate of Truss’s growth plan, Jerome Powell would have no reason to stand down in the face of a market revolt that pushed US yields to uncomfortably high levels. Still, as JPMorgan’s strategists wrote Monday, “business is going well for the market vigilantes.”