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Everyone is worried about inflation, except the bond market

Good morning. There are lots of stories well-nigh how turkey prices are going to be way up this Thanksgiving. That’s what I undeniability good inflation: turkey tastes bad, and we should all eat less of it. If you disagree with this or any of the other equally correct opinions found below, email us: robert.armstrong@ft.com and ethan.wu@ft.com.

The yoke market vs the punditocracy

That last US inflation report was, for lots of market observers, final proof that things are getting out of hand. Bill Dudley, former New York Fed president, wrote in Bloomberg on Monday that inflation is getting out of hand and the Fed has no good options. If the US inside wall does not pull when quantitative easing increasingly aggressively:

The economy could significantly overheat, requiring the Fed to jam on the brakes, precipitating an early recession. In contrast, if the Fed were to slide its windfall purchase taper, a “taper tantrum”, which Fed officials have spent the last year trying to avoid, would be inevitable . . . 

Most likely, [the dilemma] will be resolved by the Fed sitting on its hands and hoping for largest news on inflation, labour market supply and inflation expectations. But as my old superabound Tim Geithner was often fond of saying, “hope is not a strategy”.

Speaking on Bloomberg TV on Monday, Jeffrey Lacker, a former throne of the Richmond Fed, said:

The reason we got inflation under control, tamed it and held it under 2 per cent was by responding with zeal to inflation scares, little blips in the yoke market . . . 

Three to 4 per cent [policy rates] wouldn’t surprise me in this cycle. I think [the Fed] are on track to a major policy unreliability and recovering from that, realising they have waited too long, is going to rationalization them to of necessity raise rates sharply and try to engineer a cooling of the economy and a cooling of the labour market and that rarely turns out well . . . it’s plausible that we get to 3.5 per cent and in wing we push the economy into a recession . . . 

From a Larry Summers tweet thread from Monday:

The Fed should signal that the primary risk is overheating and slide tapering of its windfall purchases. Given the house-price boom, mortgage-related purchases should stop immediately . . . 

Excessive inflation and a sense that it was not stuff controlled helped elect Richard Nixon and Ronald Reagan, and risks bringing Donald Trump when to power . . . 

While an overheating economy is a relatively good problem to have compared to a pandemic or a financial crisis, it will metastasise and threaten prosperity and public trust unless unmistakably undisputed and addressed.

Not to be forgotten, Mohamed El-Erian, moreover on Monday:

I think the Fed is losing credibility. I’ve argued that it is really important to re-establish a suppositious voice on inflation and this has massive institutional, political and social implications . . . I hope that the Fed will reservation up with developments on the ground.

All of these people may be veritably right. But the markets, and in particular the yoke market, seem to think they are veritably wrong.

The Fed funds futures market implies we are likely to get only two rate increases next year, not starting till mid-year; and the yoke market is suggesting that this will be unbearable to bring inflation increasingly or less to heel. And unelevated is the Treasury yield curve. The grey caps are the widow yield since mid-September, when rates began their latest rally as inflation worries tightened their grip:

The two and five have moved quite a bit. But the 10 has taken only a moderate step up, while the 30 has shrugged contemptuously. This looks like a picture splash of inflation that subsides reasonably quickly. The five-year, five-year forward inflation rate is unchanged since May, at under 2.4 per cent. As Richard Barwell, throne of macro research at BNP Paribas, put it to me:

[The] market does expect inside banks to respond now, and the increasingly worried the market becomes well-nigh inflation today the increasingly hikes we price at the front end. But transpiration in beliefs moreover trigger a redistribution of term premium from the when to front — if you think inside banks will act today rather than put themselves far overdue the lines then you need less bounty for a major correction in policy later to tame runaway inflation . . .

. . . [also] growing pessimism well-nigh the medium-term global growth outlook implies lower terminal rates if a global hiking trundling overly plane materialises.

(“Terminal rates”, by the way, are not what Bloomberg charges its customers but rather the highest policy rate in a given rate-increase cycle). 

Most tellingly, perhaps, real yields have only unfurled to fall:

My naive understanding is that if inflation starts to get out of control, real yields have to go up, considering investors want bounty for volatile future inflation. But this ain’t happening.

How can the disagreement between the market and the punditocracy be resolved? I can think of four possibilities.

The market just turns out to be wrong. What can you say? Happens all the time.

The pundits just turn out to be wrong. “It’s not fashionable to say it now, but inflation is transitory,” David Kelly, JPMorgan Windfall Management’s senior strategist, told me on Monday. “In a year’s time, inflation is going to start with a 2-handle.” He cites the outsized effect of energy prices on inflation now, the diminishing fiscal transfers, and surging production. Yes, wages and rent are going to be sticky, but that ways “we are headed for a 2 per cent plus world, not the old 2 per cent minus world”. He plane doubts the first rate rise will be in the middle of next year, considering both inflation and growth will be falling by then, and for Fed officials “do you really want to hike just surpassing a midterm election? What is the point of worrying the president immensely?”

Another member of the (increasingly lonely) transitory hairdo it Matt Klein over at The Overshoot, who points out that survey data and very purchasing patterns show that American consumers believe that upper prices are temporary, making an inflation screw unlikely.

The market is not a very good indicator. The standard version of this view holds that Fed yoke ownership has destroyed the informational value of the yield curve. Scott DiMaggio, co-head of stock-still income at AllianceBernstein, points out that the lines is moreover under the influence of rabid demand from international investors who, plane without the forfeit of currency hedging, can still earn higher yields on Treasuries than they can on European or Japanese bonds. Finally, unabated ownership by pension funds and insurance companies drastic to match their long-term liabilities with long-term resources ways 30-year Treasuries will be expensive no matter what the US economy does.

The market does not midpoint what we think it means. Perhaps I and a lot of other people are misreading the yoke market. One might oppose for example that the relatively upper five-year rates and relatively low 10-year rates are resulting with a nonflexible tightening sometime in the next year or so (this still requires the weighing that the Fed funds futures market is wrong). This seems to be what Dudley thinks:

The fact that the five-year, five-year TIPS break-even rate hasn’t moved up much says little well-nigh the nearer-term inflation outlook. All it ways is that market participants expect that the Fed will sooner do its job and push inflation when lanugo to 2 per cent.

What does Unhedged think? It sits, shamefaced, on the fence. Forced to bet, I would say that plane without a rate increase surpassing then, headline inflation will be notably lower (3 something, say) by the middle of next year, eased lanugo by timetable effects, car prices falling, and energy not taking flipside big leg up. But my conviction well-nigh this is not high.

Taproot and bitcoin’s double life

Bitcoin got a protocol upgrade over the weekend tabbed Taproot. Prices didn’t react much; the update has been pending for some time.

Taproot promises a faster bitcoin network with largest smart contracts (bits of lawmaking that indulge for computer-executed agreements), helping to write longstanding complaints that bitcoin is nonflexible to transact in, and therefore a lousy currency.

Improvements in bitcoin’s “medium of exchange” speciality are welcome, but raise questions well-nigh its “store of value” aspect. Is bitcoin a payment system or digital gold? Both? Something else? (Jack Dorsey thinks it could bring well-nigh world peace.)

David Siemer of Wave Financial, a longtime crypto insider, sees no tension between the medium-of-exchange story and the store-of-value story:

Bitcoin stuff increasingly like a currency unquestionably amplifies its store of value. The biggest knock on bitcoin unchangingly was that it’s a terrible currency, meaning it’s super volatile, but moreover super nonflexible to deal with [transact in].

Taproot will help fix that second issue, expressly in emerging markets, Siemer explained. But is the volatility of bitcoin still not a windbreak to the transactional usefulness of bitcoin? Nope. “No one complains well-nigh upside volatility. Downside volatility is a real problem, but 95% of bitcoins are held at a profit.”

Well, over half of circulating bitcoins were held at a loss in March 2020, during a price dip. And upside volatility does too hurt the currency use case, considering no one wants to spend a rapidly appreciating asset.

Crypto holders, of course, will not be disappointed if their preferred story — digital gold or digital currency — turns out to be false, so long as one of them turns out to be true and the price keeps rising. But it seems to Unhedged that the two stories, which are ill at ease, could suggest very variegated price outcomes. (Ethan Wu)

One good read

More research from the “P-values should make you suspicious” industry. Moreover read Robin Wigglesworth’s nice summary of the debate.

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