Tightening Expectations Too Aggressive as Inflation Likely to Cool Next Year

 

Gone Till November

Wyclef Jean, 1997

What’s Next?

Omicron and Powell: A double whammy

Growth and inflation premia repriced starkly in November, especially at the end of the month with news on the omicron variant and Chairman Powell making the case to lawmakers that the Fed was ready to tame prices. Global equities were broadly lower, with the MSCI AC World index falling -2.4%, but emerging markets suffered more, as they struggled throughout the month and finished down -4.1%. Dispersion was significant: the MSCI World Tech sector was up 2.6% on the month while the Energy sector was down -6.9%. Bonds rallied, with the yield on US 10-year T-notes down -11bps to 1.45% and the Barclays Global Aggregate up 0.7%. Real assets suffered with breakeven inflation rates falling and the Bloomberg Energy index down -17%. The US dollar rose 1% on a trade-weighted basis and the JP Morgan EM Currency index fell -4%. A broadly risk-on month transformed into risk-off in the span of just a few days.

Market expectations are clear: at least two hikes next year

While uncertainty about the omicron variant makes it challenging to form strong views following the volatile end of month, the outlook for monetary policy seems clearer to us. Powell’s hawkish comments to members of Congress, which seem to have been prepared ahead of time, look aligned with market expectations, pricing interest rate lift-off for the middle of next year. As Figure 1 shows, the first hike is essentially completely priced in for the June meeting and the market expects somewhere between two to three hikes for 2022. While Fed members’ expectations could change, the market is pricing significantly tighter policy than the median projection of one hike from the September meeting.

Figure 1: Number of Hikes/Cuts Priced for Fed Meetings

Source: Bloomberg, Unigestion, as of 02.12.2021.

It is helpful to put such a tightening cycle in the all-too-recent context of asset purchase tapering and rate hikes. As Figure 2 shows, the Fed waited a year after ending quantitative easing (QE3) before its first rate hike at the December 2015 meeting. It then waited another year before the second hike. Of course, the macro picture in 2015-2016 was markedly different from today, in particular, inflation pressures were muted and the job market was quite robust. However, the takeaway from this historical context is that the Fed has largely shown cautiousness over the last few years, letting shifts in policy flow through and assessing the outcome before engaging further. Put another way, they tend to “tap the brakes” rather than slam their foot down.

Figure 2: Fed Balance Sheet and Target Rate

Source: Bloomberg, Unigestion, as of 01.12.2021

So how concerning is inflation?

We have been communicating since the end of last year that inflation would be a key macro force in 2021 and drive market returns, as the post-crisis demand recovery would meet supply and labour constraints. We reiterated that it would prove more durable than central bankers expected and not simply the result of base effects. Heading into the next year, however, we believe inflationary forces will peak through a combination of slower (though still healthy) demand and a gradual . This does not necessarily mean inflation will fall back to the 2% target, but rather that it will ease considerably, thereby relieving pressure on the Fed to tighten too fast.

Savings rates have declined significantly, so we do not see a massive source of pent-up demand. At the same time, new capacity is being brought online and supply issues are expected to be in the early part of next year. Moreover, as we mentioned last week, food, energy and other commodities are responsible for over half of headline inflation this year while less volatile components such as shelter and medical care grew at an elevated but more sustainable pace and only contributed 1.9% to the 6.2% y/y rise in the CPI. Absent an extraordinary surge in these core components, food and energy prices would need to see another upswing like the one in 2021 to keep inflation at these levels, implying oil trading at over 125 USD/bl. Indeed, market pricing suggests that commodity prices are set to fall in 2022, as shown in Figure 3, which aligns with lower demand and increased supply expected next year.

Figure 3: Commodity Futures Curve Pricing

Source: Bloomberg, Unigestion as of 01.12.2021.

Positive in the medium-term but cautious short-term

With the market having absorbed two, possibly three, rate hikes next year, the question for investors is whether they expect more or fewer hikes. We are squarely in the camp of fewer: we expect the inflationary pressures that are pushing the Fed toward tightening to ease, even if inflation remains above the 2% target in their new AIT framework. That being said, if inflation fails to cool early next year – perhaps due to persistently high wage inflation a price spiral or a geopolitical shock that pushes energy commodities still higher – we are ready and willing to adapt to this new context. In the meantime, we await more clarity on the threat of the omicron variant or further position clearing to re-engage risk, as the de-pricing of rate hikes would prove to be broadly supportive to markets next year.

Unigestion Nowcasting

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