Blog Posts — September 1, 2022

Hoping for inflation to come down? Beware of what you wish for…

by Christoph Schon, CFA, CIPM

We seem to find ourselves in paradoxical times. The first half of 2022 was characterized by tumbling share prices and soaring bond yields; both fueled by skyrocketing consumer prices. As central banks began fighting back by aggressively raising their policy rates, inflation expectations started to come down again, and financial markets briefly recouped some of their previous losses. However, now that breakeven inflation rates are once more descending toward their long-term averages, stock and bond markets have taken another turn for the worse as traders evaluate the long-term economic costs of tighter monetary conditions. Our stress tests generated in Axioma RiskTM indicate that further rate hikes could mean even more bad news for stocks and bonds alike, even if, or rather because, they help bring down anticipated consumer-price growth.

The 10-year US Treasury breakeven inflation rate has finally settled back into its long-term average range of 1.5% to 2.5%. Or as Federal Reserve Chair Jerome Powell put it in his speech at the Jackson Hole Economic Symposium: “Today, by many measures, longer-term inflation expectations appear to remain well anchored.” Financial markets seem to agree that the Fed’s aggressive tightening of monetary conditions will eventually pay off and that inflation will revert to the central bank’s target of 2%. But Powell also noted that “reducing inflation is likely to require a sustained period of below-trend growth.” Market participants appear to share his assessment, and the recent stock and bond market reactions reflect this.

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Inverted yield curve = economic growth concerns

An inverted sovereign yield curve has customarily been a reliable indicator of heightened recession concerns and more often than not, GDP growth did eventually turn negative following past inversions. Short sovereign yields are sensitive to monetary policy and customarily mimic anticipated central bank action, whereas longer maturities tend to reflect future economic growth and inflation prospects. When short rates rise above long yields, the implied assumption is that the higher borrowing costs in the near term will adversely affect conditions further down the line.

Figure 1. US Treasury yields and Federal Funds target rate

Source: U.S. Treasury

The current inversion of the US Treasury curve in Figure 1, therefore, expresses the view that the higher rates now (incorporated in the short end) will eventually bring consumer-price growth down, but at the cost of slower economic growth. The subdued 10-year yield reflects these reduced growth expectations.

Higher central bank rates = lower stock and bond prices

While the impact of central bank rates on fixed income securities is relatively deterministic (higher rates = higher yields = lower prices), the effect on equities is far less clear-cut. It rather depends on the motivation behind and the timing of the policy decision. Expansive monetary conditions are usually positive for financial markets, but if the central bank leaves it too late, slashing rates can smack of panic, and share prices could tank in response. The same applies to tightening monetary policy. A well-timed, gradual increase in rates can instill trust that the economy is growing and that the central bank is merely keeping a watchful eye so that things do not overheat. This could, for example, be observed during the so-called “Trump rally” in the wake of the 2016 presidential election, when US share prices rose by more than 40%, while the Federal Reserve raised its target corridor by 150 basis points.

Figure 2. US share prices versus monetary-policy expectations

Sources: Qontigo, CME Group

However, there appears to be a growing consensus among market players that this time, the Fed has waited too long before hitting the monetary brakes. The green line in Figure 2 represents the price of the 30-day federal funds future expiring in March 2023. The instrument is quoted in a way that the anticipated effective fed funds rate can be derived by subtracting the price from 100. It shows that as recently as September last year, traders were still largely buying into the central bank narrative that inflationary pressures were “transitory”, that consumer prices would eventually revert to their long-term average growth rate, and that no major tightening of monetary conditions would be necessary. Since then, investors have gradually raised their rate-hike expectations to currently 3.75-4.00%. The impact of share prices has clearly been negative, and despite a strong rally earlier this summer, the STOXX® USA 900 index is down more than 15% year-to-date.

Lower inflation expectations = falling share prices

When consumer prices are “well-behaved”, stock markets and inflation expectations tend to move in tandem. As the economy grows, demand for raw materials, finished goods and services increases, and prices rise. Central banks then start raising policy rates, money supply dries up, demand slows down, the economy cools off, and share and inflation expectations ease once more. The only exceptions are usually times when excessive inflation is expected to erode future cash flows, especially for growth stocks, where most of the anticipated revenues and profits are in the distant future.

Figure 3. US share prices versus inflation expectations

Source: Qontigo

Figure 3 shows the interplay of US share prices and long-term inflation expectations, represented by the STOXX® USA 900 index and the 10-year US Treasury breakeven-inflation rate, respectively, since the start of 2020. It highlights the close co-movement of the two market indicators, even at the height of the COVID pandemic. The first minor breakdown in the relationship occurred in early 2021, when breakeven rates approached the upper threshold of their long-term range of 1.5% to 2.5%. The Federal Reserve temporarily managed to calm down markets, and share prices continued to climb, while breakeven rates stabilized. However, the Russian invasion of Ukraine in February 2022 pushed inflation expectations yet higher, and equity markets finally turned. The decisive monetary tightening that followed pushed breakeven rates down once more, but this time, share prices followed over concerns of the adverse impact of higher borrowing costs, and the interaction between the two-time series is once again positive.

Higher nominal yields – lower breakeven rates = higher real yields

Rising costs of living over time erode the future value of money. Investors, therefore, expect their investments to generate a return greater than inflation. For debt securities, the calculation is straightforward: if the yield to maturity is greater than the breakeven inflation rate, then buyers can expect their wealth to increase in “real” terms. However, when real yields are negative, investors essentially lose money, even when the nominal yield is greater than zero. One would, therefore, expect nominal borrowing rates to increase if inflation expectations rise.

Figure 4. US yields and breakeven inflation

Source: Qontigo

Figure 4 shows the 10-year US Treasury yield in blue and the corresponding breakeven inflation rate in green, with the light blue area representing the difference between the two. We can see that the real yield was positive at the start of 2020, but then turned negative as inflation expectations recovered with share prices (see Figure 3) over the remainder of the year, while nominal yields remained depressed by safe haven buying and extensive quantitative easing from the Federal Reserve. The relationship between nominal yield and breakeven rate remained mostly stable throughout 2021, resulting in an almost constant real yield of around -1%. Once the Fed stopped buying government debt and started raising rates aggressively in March 2022, nominal yields took off once more, eventually overtaking implied inflation rates in early May.

Stress-testing even tighter monetary conditions

Chair Powell left no doubt in his Jackson Hole speech what the Fed’s priority will be over the coming months and, possibly, years: “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” He then concluded that: “We will keep at it until we are confident the job is done.” US headline inflation has shown some signs of having peaked recently, with consumer prices remaining unchanged from June to July. More importantly, core inflation, which excludes the more volatile energy and food components, has been falling since March. Yet, Powell warned that it would take more than “a single month’s improvement” to make the FOMC “confident that inflation is moving down.” So, there is clearly a risk that the Fed may turn monetary screws even tighter than currently anticipated. This would be yet more bad news for stock and bond markets alike. And even though higher central-bank rates might help bring down inflation expectations further, the financial market impact is still likely to be negative for most asset classes.

Figure 5 shows simulated returns for US equities and different fixed income asset types under two scenarios. The lower half represents an environment, in which the Federal Reserve raises its target corridor by 50 basis points more than what is implied by the March 2023 fed funds futures at the moment. The upper-stress test simulates what would happen, if the 10-year breakeven inflation rate were to decline another 0.5% as a result, effectively returning to its long-term average of 2% from current levels. Both transitive stress tests were calibrated on daily returns over three months to August 29, 2022. The bond returns were normalized to an average duration of 7 years.

Figure 5. Simulated returns for selected USD assets

Source: Qontigo

The stress test results show that tighter monetary conditions would be uniformly bad for all equity and fixed income instruments. However, the picture is less clear-cut for easing inflation expectations. Due to the currently positive correlation between share prices and breakeven inflation (Figure 3), the BEI scenario predicts a 5% loss for the US stock market, if the 10-year breakeven rate were to decline by half a percent. Treasury Inflation Protected Securities (TIPS) are also likely to suffer, as their cashflows (coupons and final repayment) are linked to realized CPI growth. Yet, nominal Treasury bonds seemingly benefit from lower inflation expectations, due to the once more positive correlation of nominal yields and breakeven rates in recent weeks (Figure 4). Credit spreads, on the other hand, seem to be more driven by share prices. Widening risk premia on high-yield securities in particular appear to far outweigh any decreases in risk-free rates, whereas the two effects seem to cancel each other out for higher-rated corporate bonds.

And the winner is…

There was a consistent winner in both scenarios, however. Higher interest rates tend to make a currency more attractive to foreign investors, and the consistent appreciation of the US dollar against most of its major trading partners over the past 12 months certainly reflects that. Of course, one could argue that other major central banks will likely catch up with the Federal Reserve at some point, narrowing or even eliminating the interest rate differential. Notably, the Bank of England (BoE) is currently expected to raise its base rate to the same levels as its American counterpart, trying to stave off the high double-digit rates of inflation predicted for the beginning of next year. However, the BoE also expects the United Kingdom to enter a prolonged recession of up to 15 months, which means that it will probably not maintain the high levels of interest rates for as long as the Fed. In  light of these diverging economic growth projections on either side of the Atlantic, the predicted dollar appreciation appears justified.


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