Everyone is worried about inflation, except the bond market

Good morning. There are lots of stories about how turkey prices are going to be way up this Thanksgiving. That’s what I call good inflation: turkey tastes bad, and we should all eat less of it. If you disagree with this or any of the other equally correct opinions found below, email us: robert.armstrong@ft.com and ethan.wu@ft.com.

The bond market vs the punditocracy

That last US inflation report was, for lots of market observers, final proof that things are getting out of hand. Bill Dudley, former New York Fed president, wrote in Bloomberg on Monday that inflation is getting out of hand and the Fed has no good options. If the US central bank does not pull back quantitative easing more aggressively:

The economy could significantly overheat, requiring the Fed to jam on the brakes, precipitating an early recession. In contrast, if the Fed were to accelerate its asset purchase taper, a “taper tantrum”, which Fed officials have spent the last year trying to avoid, would be inevitable . . . 

Most likely, [the dilemma] will be resolved by the Fed sitting on its hands and hoping for better news on inflation, labour market supply and inflation expectations. But as my old boss Tim Geithner was often fond of saying, “hope is not a strategy”.

Speaking on Bloomberg TV on Monday, Jeffrey Lacker, a former head of the Richmond Fed, said:

The reason we got inflation under control, tamed it and held it under 2 per cent was by responding with alacrity to inflation scares, little blips in the bond market . . . 

Three to 4 per cent [policy rates] wouldn’t surprise me in this cycle. I think [the Fed] are on track to a major policy blunder and recovering from that, realising they have waited too long, is going to cause them to of necessity raise rates sharply and try to engineer a cooling of the economy and a cooling of the labour market and that rarely turns out well . . . it’s plausible that we get to 3.5 per cent and in addition we push the economy into a recession . . . 

From a Larry Summers tweet thread from Monday:

The Fed should signal that the primary risk is overheating and accelerate tapering of its asset purchases. Given the house-price boom, mortgage-related purchases should stop immediately . . . 

Excessive inflation and a sense that it was not being controlled helped elect Richard Nixon and Ronald Reagan, and risks bringing Donald Trump back to power . . . 

While an overheating economy is a relatively good problem to have compared to a pandemic or a financial crisis, it will metastasise and threaten prosperity and public trust unless clearly acknowledged and addressed.

Not to be forgotten, Mohamed El-Erian, also on Monday:

I think the Fed is losing credibility. I’ve argued that it is really important to re-establish a credible voice on inflation and this has massive institutional, political and social implications . . . I hope that the Fed will catch up with developments on the ground.

All of these people may be absolutely right. But the markets, and in particular the bond market, seem to think they are absolutely wrong.

The Fed funds futures market implies we are likely to get only two rate increases next year, not starting till mid-year; and the bond market is suggesting that this will be enough to bring inflation more or less to heel. And below is the Treasury yield curve. The grey caps are the added yield since mid-September, when rates began their latest rally as inflation worries tightened their grip:

The two and five have moved quite a bit. But the 10 has taken only a moderate step up, while the 30 has shrugged contemptuously. This looks like a picture burst of inflation that subsides reasonably quickly. The five-year, five-year forward inflation rate is unchanged since May, at under 2.4 per cent. As Richard Barwell, head of macro research at BNP Paribas, put it to me:

[The] market does expect central banks to respond now, and the more worried the market becomes about inflation today the more hikes we price at the front end. But change in beliefs also trigger a redistribution of term premium from the back to front — if you think central banks will act today rather than put themselves far behind the curve then you need less compensation for a major correction in policy later to tame runaway inflation . . .

. . . [also] growing pessimism about the medium-term global growth outlook implies lower terminal rates if a global hiking cycle ever even materialises.

(“Terminal rates”, by the way, are not what Bloomberg charges its customers but rather the highest policy rate in a given rate-increase cycle). 

Most tellingly, perhaps, real yields have only continued to fall:

My naive understanding is that if inflation starts to get out of control, real yields have to go up, because investors want compensation for volatile future inflation. But this ain’t happening.

How can the disagreement between the market and the punditocracy be resolved? I can think of four possibilities.

The market just turns out to be wrong. What can you say? Happens all the time.

The pundits just turn out to be wrong. “It’s not fashionable to say it now, but inflation is transitory,” David Kelly, JPMorgan Asset Management’s chief strategist, told me on Monday. “In a year’s time, inflation is going to start with a 2-handle.” He cites the outsized effect of energy prices on inflation now, the diminishing fiscal transfers, and surging production. Yes, wages and rent are going to be sticky, but that means “we are headed for a 2 per cent plus world, not the old 2 per cent minus world”. He even doubts the first rate rise will be in the middle of next year, because both inflation and growth will be falling by then, and for Fed officials “do you really want to hike just before a midterm election? What is the point of annoying the president immensely?”

Another member of the (increasingly lonely) transitory crew it Matt Klein over at The Overshoot, who points out that survey data and actual purchasing patterns show that American consumers believe that high prices are temporary, making an inflation spiral unlikely.

The market is not a very good indicator. The standard version of this view holds that Fed bond buying has destroyed the informational value of the yield curve. Scott DiMaggio, co-head of fixed income at AllianceBernstein, points out that the curve is also under the influence of rabid demand from international investors who, even after the cost of currency hedging, can still earn higher yields on Treasuries than they can on European or Japanese bonds. Finally, incessant buying by pension funds and insurance companies desperate to match their long-term liabilities with long-term assets means 30-year Treasuries will be expensive no matter what the US economy does.

The market does not mean what we think it means. Perhaps I and a lot of other people are misreading the bond market. One might argue for example that the relatively high five-year rates and relatively low 10-year rates are consistent with a hard tightening sometime in the next year or so (this still requires the belief that the Fed funds futures market is wrong). This seems to be what Dudley thinks:

The fact that the five-year, five-year TIPS break-even rate hasn’t moved up much says little about the nearer-term inflation outlook. All it means is that market participants expect that the Fed will eventually do its job and push inflation back down to 2 per cent.

What does Unhedged think? It sits, shamefaced, on the fence. Forced to bet, I would say that even without a rate increase before then, headline inflation will be notably lower (3 something, say) by the middle of next year, eased down by calendar effects, car prices falling, and energy not taking another big leg up. But my confidence about this is not high.

Taproot and bitcoin’s double life

Bitcoin got a protocol upgrade over the weekend called Taproot. Prices didn’t react much; the update has been pending for some time.

Taproot promises a faster bitcoin network with better smart contracts (bits of code that allow for computer-executed agreements), helping to address longstanding complaints that bitcoin is hard to transact in, and therefore a lousy currency.

Improvements in bitcoin’s “medium of exchange” aspect are welcome, but raise questions about its “store of value” aspect. Is bitcoin a payment system or digital gold? Both? Something else? (Jack Dorsey thinks it could bring about world peace.)

David Siemer of Wave Financial, a longtime crypto insider, sees no tension between the medium-of-exchange story and the store-of-value story:

Bitcoin being more like a currency actually amplifies its store of value. The biggest knock on bitcoin always was that it’s a terrible currency, meaning it’s super volatile, but also super hard to deal with [transact in].

Taproot will help fix that second issue, especially in emerging markets, Siemer explained. But is the volatility of bitcoin still not a barrier to the transactional usefulness of bitcoin? Nope. “No one complains about upside volatility. Downside volatility is a real problem, but 95% of bitcoins are held at a profit.”

Well, over half of circulating bitcoins were held at a loss in March 2020, during a price dip. And upside volatility does too hurt the currency use case, because no one wants to spend a rapidly appreciating asset.

Crypto holders, of course, will not be disappointed if their preferred story — digital gold or digital currency — turns out to be false, so long as one of them turns out to be true and the price keeps rising. But it seems to Unhedged that the two stories, which are ill at ease, could suggest very different price outcomes. (Ethan Wu)

One good read

More research from the “P-values should make you suspicious” industry. Also read Robin Wigglesworth’s nice summary of the debate.