(3D/L) Stress in the bond markets can be easily traced to rumblings from the Fed about the inevitable end to the easy money party as well as what might be called a second order fear of inflation, that is, a concern that the Fed is concerned about inflation and may act accordingly.
We have our own second order inflation fear. In what is nearly a cliché, we worry that others are not worried enough. Yes, we do think that the probability of a sustained and significant round of inflation is relatively high. But our outlook is still one of probabilities rather than prediction. What troubles us is how low the market prediction of inflation seems to be. The fear is that the scales may drop suddenly from the eyes of investors and the consensus inflation expectations will leap up to a level in line with our outlook, causing dislocation in the markets.
Thoughtful readers may object that inflation has been on everybody’s lips for a while, particularly in the wake of October’s CPI data release a few weeks ago and Fed Chairman Powell’s warnings at the end of the month. Surely inflation anxiety is already widespread and “priced in” to the market? We are not so sure.
The most direct indicator of the market’s inflation outlook is the spread between inflation protected Treasury bonds (TIPS) and their ordinary Treasury bond counterparts. (Indeed, creating a clear measure of inflation expectations was one of the reasons the Treasury invented TIPS in the 1990s.) This so-called “breakeven rate” for ten-year bonds ended November at 2.50%, down from 2.51% at the start of the month.
That is a bit elevated from historical levels, the average over the 2010-2020 decade was 1.99%, but only a bit. How can this be reconciled with all the buzz about inflation? Perhaps TIPS are unloved for some reason and underpriced, making the inflation reading misleadingly low. But the breakeven rate seemed to work in the past, running at about the experienced level of inflation.
The more conspiracy minded might suspect that the Fed has been skewing the results by buying up regular Treasury bonds and avoiding TIPS. In fact, the opposite appears to be true. Earlier this year there were concerns that the breakeven rate was artificially high because the Fed was buying TIPS too aggressively.
And just to be clear, the breakeven rate is not a mere abstraction. It is an easily executed trade. Even a retail investor can buy TIPS and short regular Treasuries, either directly in the bond market or using ETFs. And there are ETFs that do both sides of the trade for you in one simple package.
To our minds, the failure of the market to put its money where its mouth is can best be understood as a cognitive problem. It is very hard to take action based on the threat of something that you understand intellectually but that is far outside your past experience. And in this sense inflation is a bit of a generational problem.
There are very few investors active today who experienced the inflation of the 1970s and early 80s. When oldsters like us say we remember inflation we often mean that we experienced it as children. For most investors, born after 1975 or so, inflation is a bogeyman that, at best, they learned about in college. Much like global warming, it is a threat that is easy to acknowledge in principle but hard to confidently do anything about.
And in some ways, widespread unfamiliarity with inflation makes it worse. A business experiencing an increased demand for its products can do one of two things. It can increase production or raise prices. In typical non-inflationary times, the right answer is usually to increase production, if possible. Raising prices might mean losing market share to a rival or inducing customers to buy something else.
But under inflation, the perceived increase in demand is a mirage. If the money supply has increased, the dollars being offered for the products are worth less than they used to be. In effect, inflation has increased demand by decreasing real prices. Increasing production would be a mistake, as the cost of inputs will soon rise, which will eventually lead to having to raise prices and reduce production after all. In the meantime, the business will spend money to produce more product than there is actual demand.
Depending on your outlook, you might view this fooling of businesses (and people) to be a good thing, because it stimulates the economy, or a bad thing, because there is an unavoidable fallout once the mistake is discovered.
In both respects, the positive short term effect and the negative long term one, the scale of the inflation impact is driven by how often and by how much economic actors are surprised. And that has a lot to do with their previous experience. By the end of the 1970s, policymakers found that increasing the money supply no longer had the economy stimulating effects it once did, because by then everybody was wary of inflation and more likely to raise prices than increase production. Today, the opposite is true. The economy is populated by actors who have never dealt with inflation before.
Capital markets are also now populated by those unfamiliar with inflation. The mistakes that they might make are not as obvious, but an overly complacent view of fixed income might be a good place to start. Even a modest round of inflation over a few years would render real returns on Treasuries strongly negative. That in and of itself is not a disaster, nor is it unprecedented.
The trouble is that so far the market seems to be stubbornly holding on to inflation expectations based on experience of the previous few decades rather than on current evidence. It could be that the market will gradually adapt to a new outlook, but it is just as possible that the adjustment will be sudden, involving sharp price movements and not a little amount of irrationality. And that is something worth worrying about.
The Market Sentiment Framework
We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.
The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant anduncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.
Both the Optimism and Efficiency levels were nearly unchanged in November.
Optimism began the month at 0.09 and ended at 0.02. Although still relatively low in absolute terms, Optimism is well above its pandemic lows and not that far from its post-COVID high of 0.70 seen in mid-April of this year.
Efficiency rose slightly, starting the month at -0.41 and ending at -0.21. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is still under stress.
Both measures are higher than where they were in early 2020, but have trended lower since the spring. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with modestly optimistic but still fearful investors. This would imply a positive but challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.
