Investors are still in denial about inflation and interest rates
“Central bankers are in an unenviable position,” Ben Wright told the Daily Telegraph. “They must choose between death by a thousand price hikes or the electroshock therapy of massive interest rate hikes.” There are worrying signs that inflation is taking hold in the economy. UK service sector inflation hit 5.9% in August, threatening a “wage-price spiral”. Even if headline inflation peaks soon, it could then remain “well above central bank targets for much longer than expected.”
With energy prices falling, concerns on both sides of the Atlantic have shifted to core inflation, the measure that excludes volatility in food and energy prices, says Hermione Taylor in Investors’ Chronicle. The UK’s costly ‘new energy price regime’ means the inflation outlook has improved dramatically, banishing talk of consumer price inflation above 20%.
But core annual inflation rose to 6.3% in August. The prospect of “stubbornly high” underlying inflation shows that “we are not out of the woods yet”. Repeated inflationary shocks have kept central bankers in tightening mode. This week’s full percentage point jump in Sweden was the biggest jump since the 1990s.
Many investors are still holding out hope for a “Fed pivot…the mythical moment when it decides to slow the interest rate hikes that have sent asset prices skyrocketing this year,” Katie Martin told the Financial Times. The upshot is that traders have had “a swoon every time this year that US inflation data has been surprisingly strong.”
You’d think they would have gotten the message by now, but it seems some are having a hard time adjusting to the new reality. “It’s the…triumph of hope over experience,” says Trevor Greetham of Royal London Asset Management. “It’s a massive regime change. People always want inflation to be transient and temporary.
A Goldilocks scenario?
Surveys of asset managers show that market opinion is currently split evenly between bulls and bears, says John Authers on Bloomberg. Bulls are betting that the threat of recession will cause the Fed to turn to an easier currency “in the coming months”. Still, “inflation is too entrenched for the Fed to reduce it much, if at all, by the end of next year.” Count me a “bear”.
The problem with the bull case is that the only thing that will make the Fed change course is a bad recession in the United States, says James Mackintosh in the Wall Street Journal.
“But the markets are not seriously preparing for a recession, with bets assuming instead that inflation will fall sharply without killing the economy” or severely damaging corporate earnings. Asset prices “need to fall further because investors still cling to vestiges of the belief that inflation will soon be brought under control.”