By Michael O’Neill
A tug-of-war is a game with two teams on opposite ends of a rope. The object is to pull the rope over a certain distance. Often, the losing side is dragged through a mud puddle, to the joy of detergent manufacturers everywhere.
There is another tug of war playing out in financial markets. No one gets dragged through sludge in this game. Instead, the loser will put a serious dent into their investment portfolio.
On one end of the rope is Jerome Powell and his colleagues on the Federal Open Market Committee. They are adamant that they, and only they, will decide when and how high interest rates will rise.
The other end of the rope are bond traders. They believe that US stimulus and coronavirus vaccines will unleash a torrent of consumer demand, driving up prices and inflation.
Global equity traders are interested spectators, but not unbiased. They are not just cheering for Mr Powell’s team; they are betting heavily on a Fed win.
The tug-of-war began last year. In August, the Fed sent the equivalent of the “Bat Signal” to the world. They announced that instead of failing to manage inflation to a fixed 2.0% target, they will attempt to target an average rate around 2.0%
“Attention World-Fed Speaking” Photo wikimedia
In September, Mr Powell said: “We think that the economy’s going to need low interest rates, which support economic activity, for an extended period of time … it will be measured in years. However long it takes, we’re going to be there.”
He hasn’t changed his tune. He doesn’t seem to think that inflation is a problem, and remains more concerned about deflation. In his post-FOMC press conference January 27, he said “there are significant disinflationary pressures around the world, and there have been for a while, and they persist today. It is not going to be easy to have inflation move up.”
Mr Powell isn’t worried about a plunge in the unemployment rate either. Full-employment would have forced the Fed to raise interest rates, in the past. Not now. On February 10, he referenced the revised FOMC Statement on Longer Run Goals and Monetary Policy, and noted the economies ability to sustain a robust job market without causing an unwanted increase in inflation. He said, “we will not tighten monetary policy solely in response to a strong labor market.”
Bond traders managed to drive Treasury yields higher.
The 10-year US Treasury yield closed at 0.77% on the US election date, then climbed steadily, touching 1.19% on February 5, 2021. Bond traders disagree with the Fed’s inflation outlook.
And why shouldn’t they? The Fed has an abysmal track record managing inflation. They are not alone.
Statistics Canada has introduced a personal inflation calculator as a tool to help sell the Bank of Canada’s inflation outlook. Many consumers notice that ever-day items are costing more, despite being told inflation is low. If you are not selling or buying a home, house price inflation is a moot point. The same holds true with low airfare and accommodations prices if you are adhering to a government-mandated lockdown.
The Bank of Canada almost admits inflation is higher.
The recent monetary policy statement said, “CPI inflation has risen to the low end of the Bank’s 1-3 percent target range.” But it doesn’t matter. They say the increase is temporary and excessive supply will weigh on inflation “through the projection period.” Really?
Some economists are getting concerned about new inflation risks, especially in the US. They believe that the massive fiscal support already announced, combined with Biden’s $1.4 or $1.9 trillion top-up, may unleash a surge in hiring, and consumer spending. As will higher household wealth and commodity prices. That will all happen with the Fed’s blessing to ensure they don’t derail and economic recovery.
Who does one believe-Free market traders, or government institutions?
The BoC’s political masters have a vested interest in keeping interest rates at, or near zero. The Canadian government budget deficit is so massive (nearly $400 billion), that a jump in interest rates would jeopardize pet spending programs.
The Fed isn’t any different. The Congressional Budget Office projects federal debt held by the public will be over 100% of GDP in 2021.
US equity traders are cheering for the Fed, although those cheers could turn to “boo’s” if 10-year Treasury yields break above 1.25%, and triggers a stock market correction. The Nasdaq, S&P 500, and Dow Jones Industrial Average gained 6.4%, 4.0% and 2.5% year-to-date, as of February 11.
Canadian dollar bulls have pitched their camp with the Fed. The currency traded at 79.34 cents to 1 US dollar last week, and even after a profit-taking retreat, prices are just below 0.79 cents on February 11. Expectations that the Fed will leave monetary policy unchanged is keeping Canadian dollar sentiment positive
There is an old adage in financial markets which says “Do not bet against the Fed.” Those banking on reflation trades to line their pockets may find themselves with a mouthful of mud instead. 1,2,3,4-the Fed will win this reflation war.