Peering Beyond the Thanksgiving Taper

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Key Points
  • The U.S. economy has recovered strongly, but adverse side-effects are becoming visible: a larger, and more persistent run-up in inflation and a sizable upturn in asset prices.
  • In response, the forthcoming taper has been well-telegraphed. This will be a good start. However, additional responses are starting to look increasingly necessary but seem unlikely –until Fed Chair appointment is completed and other vacancies are filled.
  • Meanwhile, market nervousness has grown on higher-than-expected inflation and a quicker reduction in unemployment –the recent bond curve flattening reflects heightened concern about earlier tightening of monetary conditions.
  • We are not downplaying inflation risks, but the market’s nervousness and the Fed’s inability or unwillingness to act quickly will continue generating volatility –as we highlighted in “Air Pocket” ourQ4’21 Vantage Point publication.
  • Nevertheless, barring even greater supply-side shocks, U.S. equities should be able to with stand such bouts of volatility on robust household balance sheets, lagged stimulus impacts and strong corporate earnings.

Chart 1: U.S. inflation hasn’t been this high since 1990s

U.S. Core CPI & FED Funds Target Rate

Source: BNY Mellon IM, Macrobond, Bloomberg U.S. Bureau of Labor Statistics (BLS).

Chart 2: Curve flattening, on fears of earlier tightening

Government Benchmarks, 2s10s

Source: BNY Mellon IM, Macrobond.

The Federal Reserve’s tapering will kick off as Americans begin loading up on their turkeys and stuffing. Asset purchases will be lowered by $15bn each month, for eight months, and should end by June 2022. The asset purchase reduction will be equally spread ($5bn each, per month) across inflation-linked bonds, cash bonds, and mortgage-backed securities.

Covid-risks have not entirely gone away. But as the threat gradually recedes, the near- and long-term (adverse) side-effects of the spellbinding recovery of the last 18 months are becoming clearer.

The near-term problem is elevated inflation. The October print of U.S. core inflation is at +4.6%y/y, its highest in over 30 years (Chart 1). It is also looking rather persistent. The longer-term threat is from the sizable run up in asset prices. In addition to the equity market rally, the U.S. housing market has
encountered a 25% run-up since early 2020. Such rapid asset price gains have re-fueled concern about income- and wealth-gaps. They have also raised rental costs and reduced labor supply. The latter has come about as more baby-boomers opt for early retirement on asset price gains. Both contribute, directly, or indirectly, to worsening inflation dynamics.

In this backdrop, our evolving view at GEIA is that tapering has been well telegraphed and should not, in it-self, be disruptive for market sentiment. However, market focus has already begun moving on to the next and most near-term macro challenge: how will the Fed credibly quell inflation, without derailing the ongoing recovery? Will these doubts and questions undermine market sentiment?

For the moment, we do not think the Fed will do anything else, aside from implementing its tapering plan. This is because the Fed, itself, is going through an internal transition. Several vacancies have emerged at the highest echelons of the central bank. What’s more, at the time of writing this note, President Biden appears to be considering at least one other contender for the role of Fed Chair –as Jay Powell’s term is set to expire in February 2022. This institutional context should preclude any sudden shift in policy or stance over the next few months.

Regardless of whether Jay Powell is re-appointed, or we get a new Chair, market sentiment has become, and could remain, more precarious. This may come about as elevated inflation pressure squares off against a Fed which, even under a new Chair, may strive to maintain policy neutrality, or may be perceived to be politically constrained, until the November 2022 mid-term elections are concluded.

To be sure, the Fed is not alone in insisting that the inflation spike is transitory, against a contrarian, and less sanguine, market view. The Bank of England and the Reserve Bank of Australia are also in the same boat; and these countries too have encountered a sizable upward shift in market yields on short-dated notes, in recent weeks, while those on longer-dated bonds have fallen modestly.

The resulting flattening of government bond yield curves, thus, highlight worries about inflationary risks being more persistent and the speed of the re-pricing in recent weeks (chart 2) also reflects a growing market view that a tightening of monetary conditions, by the Fed, could come much sooner.

Yield curve (bear) flattening typically occurs relatively later in an economic cycle as investors expect central banks to raise short-term policy rates, which pushes up short-dated yields relative to longer-term ones.

However, recent market volatility, at the front-end of bond curves, is of the type we anticipated when we framed “Air Pocket” our most recent (Q4’21) Vantage Point. Nevertheless, our fundamental view remains that risk assets, and, in particular, U.S. equities, should continue holding up reasonably well, especially cyclical and value-tilted names. The U.S. macro recovery is set to normalize, but it should continue –on the lingering effects of government stimulus, improved household balance-sheets as well as robust corporate earnings.

Chart 3. U.S. earnings remain strong

S&P 500 3rd Quarter Earnings Scorecard

Data as at November 8, 2021. Source: Strategas.

Important Information

https://www.bnymellonim.com/outlook/global-disclosure/

IS-226851-2021-11-10

GU-194 – 10 December 2022

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