The Feds too slow to react to Inflation
By sticking too long with the narrative that inflation was transitory, the Federal Reserve has reacted too late to inflation. It is still behind where it needs to be as regards the policy. What the market needs are a gradual reduction in the inflow of cash.
Twice Hit
The prevailing environment matters a lot. If you are in a disinflationary environment, you can stay loose for longer and try to raise everyone’s living standards. It makes sense to do that. However, when you have a global inflationary environment and you are trying to raise everyone’s living standards, it is difficult.
What you will eventually end up doing is to hit the most disadvantaged segment of society twice. You hit the disadvantaged segment-first of all by inflation. At the moment, the prices of commodities have started increasing. The most vulnerable segment of society will be hit by declining economic activity and there will be job losses.
What happens when inflation rises?
When inflation rises, people tend to spend a larger percentage of their income on basic necessities. We already see an increase in food and gas prices. Another method the Feds could try to adopt is to increase interest rates and try to reduce the balance sheet. This achieves a sustainable path. There’s an age-old saying that macro stability is not everything; however, without macro stability, you have very little.
Macro stability is a necessary condition. Policy response should be that the Feds move faster in taking its foot off the accelerator and doing rate hikes. Then it needs to move to increase labor participation to increase labor productivity. It also needs to do more in understanding and supervising the non-bank financial sector. This is fixable. It just needs proper implementation.
The most accurate forecasts at the moment cannot help us to predict where 10-year yields will end in the year. There has been a massive decoupling. The economy has not really mattered for financial markets. What has really mattered for the financial market is liquidity injection.
The winning strategy may no longer hold
If in 2021, your investment strategy was that the liquidity rate would continue, then you got it right. You were likely to do well in the markets. Last year and the year before have always been about liquidity. It didn’t matter what the economy did or what credit risk did. As long as you get the liquidity call correct, you are going to do well in the market and make money. So, for now, the best approach is to ride the liquidity wave tactically.
Nevertheless, the time will come when you will have to move from liquidity issues to more fundamental issues. It is likely that in 2022, we are going to see that come to play. There is an understatement of the current inflation dynamics. Who would have believed that the inflation rate in the US would be at 6.8% and the 10-year rate will be at around 1.50 would have 30-year record highs? So, the big question is whether this will last into the new year.
Supply and Demand
Again, there is a supply-demand section for bonds that if it is not gotten right, it was in the picture. The Treasury borrows to offset the deficit because it can’t produce money therefore, the Treasury needs to sell bonds. And if they are not enough buyers of those bonds, there will be issues.
The federal reserves would come in and intervene and print money to buy the ponds. Right now, the world is over-invested in US dollar-denominated bonds, and they have negative real returns, cash also has negative real returns. So, if there was the selling of that and a movement into other assets such as stocks, commodities, and other assets such as real estate and the likes, this would worsen the supply and demand balance.
The Bank of America has noticed how many times inflation has been mentioned in its note, and it has become much more frequent. A lot of attention is going into US inflation.
How serious is the inflation problem?
Inflation is on the mind of analysts and on the mind of the Feds. It’s on the mind of pretty much everyone, especially investors. The most important question for investors is, in 2022, how serious is the inflation problem? And what will be the reaction of the first to read what will be the response of the Feds to it, and what will be the reaction of the market to the Feds intervention.
What happens, for instance, when you change your portfolio allocation today in expectation and anticipation for the action of the Feds or hikes in the rates. We expect the Federal Reserve to raise the interest rate sometime in the year. We expect them to take a firm approach in terms of communication and in terms of handling the issues of the economy.
So, it is a year in which equities may be more volatile. A year in which government bonds and corporate bonds may see negative total returns. So, we see that there are better opportunities elsewhere in the market. The credit markets, for instance, or high yield corporate bonds.
When will the rate shock happen?
Analysts expect a rate shock. This rate cycle is likely to be different because, for the last 10 to 20 years, the Federal Reserve has been primarily concerned about unemployment.
So, what they have been doing is to raise interest rates until they start to see pressure in the job market. This time it is likely to be very different because the Federal Reserve is concerned little about the labor market and is more concerned about fighting inflation.
What can investors do?
What investors need to do is to start assessing their portfolio in advance in preparation for the increase in rates. Position your portfolio in advance of the rate hikes and keep cash available to take advantage of market corrections. This Is probably the best way to approach what is likely to be an unusual year.
There is a lot of debate happening on Wall Street about where the Fed's attention is now and how far will the market sell-off before the Fed will take action. So, investors need to be prepared to allocate capital away from the Fed-sensitive part of the market to other areas where there are opportunities and also to have capital available to deploy in case the Fed gets too hawkish and causes a market correction.
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