Fed sides with reflationists as bond battle resumes

US central bank sticks to view that inflation will quicken as bond market scepticism intensifies

by: John Authers

Fed governors are guiding the market towards one more rate rise this year about as directly as they possibly could © Reuters

The oldest conflict in world markets has resumed. Politics has generated excitement for the last 12 months or so, as has the notion that reflation is at last here after years of post-crisis deflationary malaise.

But this week, the outline of an old conflict has grown clear once more. The bond market is again battling central banks. And deflationists — who believe that the western world is stuck in low growth and low or negative inflation — have resumed with vigour a battle they appeared to have lost to the reflationists, who believe that the world is at last emerging from the morass.

It has not been a long respite; six months ago, the market abandoned its hostilities with the Federal Reserve after persistently betting that the central bank would not have the nerve to follow through on its own forecasts that it would raise rates — and generally winning.
Donald Trump managed to bring harmony where there had been discord, bringing everyone to believe that reflation was at hand. As the year started, the Fed predicted three rate rises this year and the market — as measured by Fed Funds futures — broadly agreed. Bond yields steadily rose to take account of the likely inflation and rate rises to come.

But that accord has now broken down. The Fed’s monetary policy-setting committee met on Wednesday, raised rates to 1.25 per cent as expected, and left its projections for the future path of rates intact. Infamously published in the form of a dot plot, they show that Fed governors are guiding the market towards one more rate rise this year about as directly as they possibly could. That is what half of them expect, while a quarter think they will raise twice, and a quarter think they will stand pat.

But despite this very clear steer, the market is positioned for something else. The Fed Funds futures market suggests another 2017 rate rise is less than a 50-50 shot, while falling bond yields imply radical dissent. At face value, two-year yields, which are now above the Fed’s target rate, imply that we are unlikely to see as much as one rate rise over the next two years.

How is this possible? In part this is a regression to old behaviour. Traders had several profitable years betting against the Fed’s dots, which persistently and incorrectly signalled that the central bank was ready to tighten.

But it is perhaps more about a straight disagreement over incoming economic data, on which the Fed says it is dependent. The biggest fall in US bond yields this week came hours before the Fed’s announcement, with the release of US inflation data. Inflation, notably core inflation excluding food and fuel prices, fell. So did retail sales. Growth in average annual real wages slowed, to 0.6 per cent — labour is indeed managing to get a slightly better deal out of capital, after inflation, but not to the extent that would make anyone worry about inflation or brace for a great increase in consumption.

Added to all this, oil prices dropped to a fresh low for the year, meaning that headline inflation — which matters most to politicians and consumers, if not central bankers — will fall further compared with previous expectations.

This latest data package looks like a convincing argument that the great Reflation Trade, ignited by China early last year and given extra fuel by the strong surveys of economic confidence that followed the US election, can now be consigned to the dustbin of history. We should all go back to worrying about deflation.

But that would be premature. Other central banks, and not just the Fed, see a reason to worry about inflation. In the UK, the Bank of England staged its own shock by revealing that three of the eight members of its rate-setting committee voted to raise rates at its latest meeting. They are worried by UK inflation, which is rising in the wake of last year’s depreciation of sterling.

The problem for the BoE is that sterling’s plunge last year has helped guide the UK economy through the aftershocks from the Brexit referendum. Higher rates would attract funds back to the UK, push up the pound (which is what happened on Thursday), and render British exports less competitive at a time of high political uncertainty.

In the US the labour market remains strong, which, according to a long-used economic theory known as the Phillips Curve, implies that inflation should be rising. Surveys of businesses still suggest renewed enthusiasm to invest, while corporate revenues are impressive. And in the eurozone, growth has startled almost everyone, after years of malaise. These are not consistent with another deflation scare.

But for now the wisdom of crowds, captured by the collective judgment of the market, is that the data once more point to deflationary forces. The wisdom of the Federal Reserve still disagrees. We are back yet again to a battle between inflationists and deflationists. Just when you thought it was safe to go back into inflation-linked bonds, the question returns. And as before, no question is more important in the world of markets.

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