Crashing Around You
While the start into 2022 has been business as usual for most people (leaving aside the ongoing measures in many western countries to combat the virus), it has been more than wobbly for international financial markets.
On the third trading day of the year, the published FOMC-minutes from December caught many market participants by surprise.
According to the Minutes, the Fed wants to be much more aggressive in its monetary policy stance than expected. Not only did the participants discuss tapering and (gradual) rate increases, obviously, they also conferred about reducing the Fed’s balance sheet much sooner, namely shortly after raising rates.
The news brought some motion into rates markets, and the 10y treasury yield has risen about 20bps since the start of 2022. Meanwhile, the curve gradually steepened, although not very much. The German 10y Bund yield followed and is currently close to 0 %.
On the other hand, equity markets in the United States and Europe got under pressure (especially growth stocks). All major US indices are currently down year-to-date, European stocks more or less unchanged, while bank indices are up in the prospect of a better interest rate environment.
Markets expect the Fed to raise rates at least three times in 2022, with a high probability of a fourth raise. While most economists and analysts claimed that inflation would be transitory last year, many of them are not that sure anymore.
I have thought a lot about the further course of inflation these days, and I expect inflation to peak soon (or probably it already peaked in December) and to come down in the coming months. Chinese producer price inflation (YoY) peaked in October and has fallen since then.
US inflation continued to accelerate in December 2021 to 7%, but if one looks at the ISM Prices Paid Index, it probably was the peak. The rising number of people calling for persistent inflation is a sign that the first wave of inflation has broken.
In the Eurozone, I expect inflation to peak a little bit later than in the United States, a) because Eurozone inflation lags US inflation, and b) because of the ECBs’ ultra-loose stance on monetary policy. Nevertheless, I guess that inflation will come down on both sides of the Great Pond. Isabel Schnabel’s warnings that the green transition will lead to future inflation are valid, but I do not expect greenflation to play a significant role in inflation in 2022.
Here I want to address that a falling rate of change in inflation is more related to global economic developments than monetary policy. Of course, the start of the Fed’s hiking cycle and tighter monetary policy globally plays a role, but the reasons why I expect inflation to come down are more structural. In my opinion, it is some kind of amusing that central bankers hop from one TV channel to the other to assure that they will fight inflation when it gets too high. Still, the notion that one can combat an inflation rate of above 5 % with four 25bps hikes in one year is very naive. I doubt that this is about anything more than to calm down markets.
When inflation got out of hand in the 1970s, it reached 14.75 % in 1980, so inflation was twice as high as it is now. To combat inflation, Paul Volcker raised the Fed Funds Rate to 20 %. Imagine what would happen if the Fed raises interest rates to 10. It would crush heavily leveraged businesses. And calculated by the Taylor-Rule, the Fed Funds Rate should be above 10 %. So, if the Fed wants to fight inflation, it has to do much more.
Another aspect, why inflation will come down in 2022 is the mere fact that 2020 and 2021 were years of massive liquidity injections into markets. The Fed bought vast amounts of US treasuries, and MBS, while the treasury ran down its General Account at the Fed. This year, not only will the Fed tightening, but the treasury will also build up its TGA. As liquidity gets drained, markets may observe some headwinds.
Furthermore, China may also be a drag on the global economy in 2022. The yearly rate of gange change of Chinese Credit Impulse has slowed for a year and turned negative half a year ago. The country’s monetary policy has been heavily expansionary, and it recently struggles with an (obviously popping) real-estate bubble. According to Felix Zulauf (on the Grant Williams Podcast), China cannot loosen monetary policy very much because it would crush the commercial banks. Thus, the Chinese economy will experience a significant economic slowdown, which would drag the European economy, which exports a lot of goods to the country in the far-east.
All that leads me to conclude that lower than anticipated economic growth will also help bring down inflation rates in the US and Europe. Economists expect real GDP growth of 3.9 % in the US for 2022 (slightly below official expectations of 4 %) and 4.2% in Europe. When I look at the economic turmoil ahead, I think that those numbers are way too optimistic and that growth numbers will disappoint a lot in the coming months.
Real income is also falling and thus will be a drag on consumption, and therefore economic growth. Chart 4 shows US Real Hourly Earnings YoY change, and the numbers for Europe are even worse as nominal wages have risen much less than in the United States.
Additionally, the EU is facing another problem: Its delusion to regulate its’ way to a carbon-neutral economy without a real plan. Brussel’s specifications are getting more and more strange: Apart from the taxonomy, in which the EU Commission wants to classify which business activities are ‘green’, it also intends to formulate fleet targets for European car manufacturers, as plans to implement further regulation to oblige private owners in the member countries to refurbish their buildings by 2030. As we all know, planet economies usually do not spur growth.
A slowing economy will be bad news for equities (especially for value stocks, while growth may celebrate a comeback), and hence I do not see much room to the upside for rates in the short run. Additionally, in contrast to common beliefs, tapering usually leads to falling bond yields, probably because the bond market is anticipating a slowdown of economic activity because of the tapering. Chart 5 shows what happened to US 10y yields after tapering announcements.
Do not get me wrong: I see slowing inflation in the short run, but I am still very confident that in the long run, inflation will return and that the second inflation wave will be higher than the first one. And I am very sure that inflation will stay above pre-pandemic levels and thus above the Fed and the ECB’s target of 2 % inflation over the medium term.
The Federal Reserve's plan to run down the balance sheet this year is a bluff, in my opinion. I should note that a gradual shrinking of the balance sheet may be possible because some bonds on the Fed’s balance sheet are expiring. Still, it will never be shrinking by $100 billion per month, as Atlanta Fed Chair Bostic stated recently. Or as former Fed trader Joseph Wang said: Comically.
I am still skeptical that we will see three or four rate hikes as the market anticipates. It will heavily depend on developments in the stock markets and how the Fed will react to a downturn of more than 10 % (something that is not unlikely in my opinion) and force its hand. It would not surprise me if the second half of this year would already mark the beginning of the next easing cycle (and another run-up for the stock market?)
A falling stock market, slower economic growth, and central banks tightening monetary policy (although the ECB probably never begins it) is an idea as bad as it sounds.
As soon as central banks (Fed & ECB) realize that tightening will strangle economic growth and China will not ease policy as much as many expect, another round of quantitative easing may be right around the corner.
However, I have knuckled my head a lot about the question of whether my scenario is valid, and inflation will peak and come down a bit before it makes another leg up, or will it stay high?
My expectation indeed would require that the current problems in the supply chain improve substantially. Maybe the Omicron variant supports that because it may lead to more and more governments throwing the towel.
Omicron is a chance: According to a study (preprint), the probability of being transferred to ICU is 74 % lower than with delta, and the likelihood of dying from it is 91 % lower. A big argument for ending global restrictions soon would positively affect global supply chains and dampen inflation.
But there is a big ‘if’: politics and its resistance to admitting mistakes and reverse course. Especially the Chinese government is following a rigorous zero-covid approach, which probably will not change until after the Olympic winter games next month. However, if China continues its policy, German virologist Alexander Kekulé recently said in his podcast that this strategy might lead to millions of Chinese being in quarantine. The result would be an enormous supply shock and thus inflationary.
If ports in China are closed due to one or two covid cases, shipping rates may go through the roof again. The Cass-Freight Index, which measures the total amount spent on freight, rose to another record high.
Further, US consumption may not revert despite the end of government stimulus checks. Once used to a higher income, it is hard to lower consumption again if income is shrinking. Recently, US Consumer Credit rose to another all-time high. What if debt finances higher consumption levels?
So probably, one of these things may crush the ‘lower inflation’ party. Here I would like to quote our last Austrian health minister: the next few weeks will be crucial…
However, as I noted above, I think that we will see higher inflation in the coming years. No government can withstand the temptation to lower debt-to-GDP levels through negative real rates, and the question will be how financial markets react.
I am not convinced that a deflationary spiral in asset prices will automatically lead to deflation in consumer prices. US labor force participation has shrunk after covid because many workers have made a fortune in the stock market and decided to retire from their previous professions. But what if asset prices go down significantly? Maybe there will be vast liquidations of financial assets and a significant increase in demand for consumption goods because of high inflation Gresham's Law)
And how will politicians react when their world is crashing around them? Who knows…
Have a great weekend!
Fabian Wintersberger
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity.)