Here comes trouble...

Market report

Latest reading of US inflation spurs further sell-off in Government bonds

Risky assets, such as stocks, remain volatile as investors absorb likely implications for central bank policy

CIO view

Markets continued to jostle this week, with the bond market setting the tone. Like most of the world’s central banks, the Federal Reserve has a challenging few quarters ahead. This week’s stand out data point was yet another eye-watering consumer price inflation report. Whether US central bankers raise interest rates in March is no longer up for debate. The question now is whether they will follow market pricing and launch with a 50 bps move rather than the 25 bps only recently suspected. Markets now see them getting to 100 bps by July.

Some are already beginning to worry about the threat of the next recession. A function of central banks being forced to choke their respective economies in order to get on top of runaway inflation. This is perhaps more visible in the pricing of the path of UK interest rates than in the US at the moment, which feels appropriate to us for now.

We need to keep in mind (at all times) that inflation remains a poorly understood phenomenon. In this context, it is perfectly possible that price pressures continue to defy gravity, base effects, and normalising demand for goods in the months ahead. As the spectre of the 1970s wage price spirals loom larger, central bankers could easily be forced into ever more draconian action in order to bring inflationary pressure to heel.

A few points to make as usual.

First, this is where the word ‘recession’ is as useless as the concept of ‘normal’ or even ‘pandemic’ in affording us meaningful insight. Even the last few decades demonstrate what a broad church of experience this term covers. Much as a closer examination of pandemics past begins to undermine your ability to draw conclusions from them as a homogenous block, the same is true of recessions.

Second, while humility remains appropriate (always!), there are still more paths ahead in our view where inflation begins to subside in the months ahead as planned. As consumers return towards the pleasures of services spend and workers return to the fray, significant pressure should be released. Meanwhile, there are few signs in the US that the private sector has ceased to believe in its central bank as a credible inflation fighting force.

Third, on current trajectory, even after the sharp shift in expectations, investors still see the Federal Reserve in accommodative territory in inflation-adjusted terms – they are still not expected to slam on the brakes, more lifting their foot off the accelerator.?

Finally, it remains the US that matters for investors. This is still the economy that sets the beat for the world’s capital markets. The UK does not matter from this perspective. The travails of the Brexit negotiations and the insouciant posture from investors throughout go some way to illustrate this. However, for those of us living here, the UK is a bit different at the moment. The headwinds a little stiffer and the inflation likely a little more problematic. The chances that the central bank is boxed into an uncomfortable corner are correspondingly more real. This is part of the reason why we remain a little more sceptical of a so far amazingly resilient sterling.

More broadly though, remember that rising interest rates do not have to be a source of wild panic even if we may not have seen them rise as briskly and broadly for many decades. There is some adjustment to do for investors still potentially, but a lot has happened already.?

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