But what about inflation?
“How did you go bankrupt?” – “Two ways. Gradually, then suddenly.”
E. Hemingway, The Sun also Rises
As a believer in the dynamic system theory of financial markets, this famous quote from Ernest Hemingway is one of the most important things to remember when dealing with markets. Changes in market regimes come in two ways: gradually, then suddenly. On Friday, I discussed my rules for forecasting and showed how different narratives have shaped the interpretation of financial markets throughout my career.
In our market outlook for the year 2019 we warned that inflation surprises are probably the most important developments that markets are not prepared for. Inflation expectations seem well-anchored and the median forecast for US inflation in 2019 is 2.0% at the moment (it was 2.3% when we wrote our 2019 outlook) with the individual forecasts ranging from 1.3% to 3.0%. At a time when headline inflation in the US is 1.9% and core inflation is 2.2%, practically nobody expects inflation to rise or the Fed to lose control over it.
At this point in time, this is probably still the prudent forecast to make and given my rules for forecasting, you should not be surprised when I expect stable to slightly higher inflation in 2019. However, I am starting to look closer at some gradual shifts under the surface of headline inflation numbers and consensus forecasts that may indicate a shift in market regime.
Since the end of 2018, Jerome Powell and his colleagues at the Federal Reserve have started to strike a significantly more dovish tone when it comes to future rate hikes. This dovish pivot culminated last week in the change in forward guidance of the Fed to a stance of “prudent patience”, indicating that the Fed will hold off on future rate hakes if it deems prudent and may soon stop hiking altogether. In fact, the Fed went as far as to say that the next move in interest rates could be either up or down. Markets reacted strongly to this announcement shifting the odds for Fed Funds rate at the end of 2019 from a 25% probability of a rate hike to a 22% probability of a rate cut. A rate hike in June has been completely priced out of the market and markets even price a 5% probability of a rate cut in June.
While Wall Street has celebrated these announcements as positive for stock markets and the economy, inflation expectations have started to shift as well. After last week’s Fed announcement, 10-year inflation expectations jumped 9bps and 2-year inflation expectations 11bps. Our chart shows that this is just the latest jump in a rising trend since the beginning of the year. I have also added German inflation expectations, which have largely moved in tandem with the US for the last couple of years but have not mirrored the increase in US inflation expectations.
To be sure, this is a short-term development that may easily revert in coming months and I am culturally inclined to panic about inflation even if there is none (in Germany, you are only allowed to study economics if you take an oath on your granny’s grave to always panic about inflation). But it may also signal the gradual shift of markets towards a view that the Fed may not be vigilant enough in fighting inflation. The chart below, thus, is one of the charts that I recommend watching in coming months. Even if inflation expectations remain well-anchored, it will teach us something about how markets interpret the Fed’s actions in the first half of 2019.
Inflation expectations in the US and Germany
Source: Bloomberg, Fidante Capital.