NN IP: The Fed’s leadership is becoming more nervous about inflation

November 25, 2021

With several representatives from the Fed having turned more hawkish and large parts of the Eurozone heading towards more Covid-related mobility restrictions, we now believe the likelihood of the Fed living up to the market’s expectations has increased and that the expectations for the ECB look even more stretched than before. To reflect these developments in our portfolios we’ve opened an overweight in German Bunds while maintaining our underweight in US Treasuries.

We’ve thought for some time that if in the second half of 2022 core CPE inflation in the US is still substantially above 2%, inflation expectations are above their 2001–08 average and wage growth has accelerated due to tight labour markets, the Fed is likely to start hiking rates. The main question remains how patient the Fed is now likely to be. Can it afford to wait for labour supply restrictions and inflation expectations to abate?

Over the past week, speeches by Fed governors Christopher Waller and Richard Clarida have suggested that the Fed might turn out to be less patient than we previously thought. Both discussed whether the pace of tapering of asset purchases should be increased. Clarida, the Fed’s Vice Chair and, unlike Waller, not necessarily seen as a hawk, is becoming more worried about inflation expectations. He considers it appropriate to stress that the Fed is determined to prevent a break-out of inflation expectations.

Ultimately, tapering might not be accelerated because it would go against earlier Fed communications and therefore create serious market unrest. But the Fed’s leadership is clearly becoming more nervous about a prolonged inflation spike, whether it is transitory or not. As a result, we have changed our base-case expectations for the Fed to two interest rate hikes before the end of 2022 – previously, we expected a first hike in 2023. The re-appointment of Jerome Powell as Chair and the appointment of Lael Brainard as Vice Chair for monetary policy do not materially change our expectations for monetary policy.

We still believe inflation is likely to be transitory

While we have changed our view of the Fed’s likely actions, we remain in the transitory inflation camp. Key to this view is that in order for there to be persistent inflation, we need to see persistent overheating of the economy. We consider this to be unlikely for three reasons. First, we estimate a negative fiscal pulse of around 5% of GDP in 2022. Second, the eventual release of the pile of excess savings that has built up should be a one-off event. And third, the current inflation spike can be explained by strong demand for goods in particular, not the overall level of demand. An eventual strong recovery in demand for services could cause a decline in demand for goods, leading to deflation in the price of goods.

In our view, inflation can only become persistent if we see a structural increase in workers’ bargaining power. This is not impossible – it will depend in large part on the success of the Biden reform package – but historical evidence shows that a hotter labour market results in increased labour supply, leading to a new equilibrium between demand and supply.

We move moderately overweight in German Bunds

With market expectations about monetary policy likely to remain volatile, we are maintaining a cautious stance in our multi-asset model portfolio. We remain neutral in equities and commodities, and only have modest active positions in fixed income.

We expect the high volatility in global rates markets in recent weeks to persist. Given the headlines about potential lockdowns in Europe and the subsequent drop in European rates, we considered it prudent to adopt a less overall directional view on global rates in the short term. So even though we still expect US Treasury yields to continue to grind higher thanks to solid economic growth momentum and a more hawkish Fed, we have added a moderate overweight in 10-year Bunds.

In recent weeks we have noticed that on days when global yields have been rising, Treasury yields have climbed more than Bund yields (see figure). However, on days when global yields have been falling, the spread between Treasuries and Bunds has not changed much.

This means that by being underweight in Treasuries and overweight in Bunds, we are keeping our exposure to the upside return potential while limiting downside risk when yields fall sharply. This is a tactical spread position that we will monitor closely. We may adjust it if new European lockdowns or a more dovish ECB were to increase the pressure on Bund yields, and also if stronger upwards momentum in US yields were to create new opportunities to increase our underweight in Treasuries.

Calm in the equity markets, but sector returns diverge

The relative calm in the global equity markets has continued. At the regional level, the Eurozone has started to lag the US and Japan, primarily due to the sharp rise in the number of positive Covid cases and the increasing pressure on the healthcare system.

In a growing number of countries, including Germany, the risk of new lockdowns is increasing rapidly. This could affect the European economic recovery, with new restrictions being enforced just at the time economic surprise indicators had started to improve and retail sales had become stronger.

For now, however, the actual impact on the market of the Covid situation has remained modest. Vaccinations have loosened the link between new cases, hospitalizations and deaths, and there has been news of successful trials of medicines against Covid.

We are starting to see more divergence in sector returns again, with the Covid winners, particularly in technology, outperforming the broader market. Consumer discretionary has also performed well, driven by the car sector and strong retail sales. Conversely, European financials have suffered from the effects of lower bond yields, while energy stocks have fallen on the back of lower oil prices. 

Still neutral in equities

The earnings momentum of the broad market has levelled off, leading to consensus estimates for 2022 earnings growth to fall from 8% a month ago to 7%. Unless nominal GDP growth were to disappoint substantially, we still think these earnings expectations are too low. 

We are maintaining our neutral stance on equities for the short term. Markets look technically overbought and investor sentiment is close to euphoric. Over the medium term, however, we are still optimistic about equities’ prospects based on a 4% equity risk premium, underestimated earnings growth potential, a high level of corporate activity and a lack of profitable alternatives in other asset classes.