"You want [inflation]?"
"I want [inflation]!"
"You can't handle [inflation]!"
So goes the infamous (and slightly bastardised) version of Jack Nicholson’s famous scene in A Few Good Men. Yes, he was talking about the truth but let's not fixate on that for the moment.
Since 2009 we have undergone the single largest financial experiment in history. We will leave it to others to plot the actual origins, but for now, we will use the financial crisis.
From that moment, we saw central banks around the world in a largely coordinated way, take interest rates down towards zero, crushing the yield curve, and moving investors up the risk curve.
At the same time, they started buying huge amounts of debt. They became the market in government debt and by proxy in investment and high yield. Like the lowest block in a game of Jenga, everything is stacked on top.
That dual-action has lifted risk assets to all-time highs, and largely in a straight line (on various relative measures we are still below 2,000 on growth stock metrics). The ultimate expression of this risk-on has been the explosion of speculative assets like crypto and NFTs. That’s not to say there is no value in these assets, but we are a long way from seeing the winners, and unpicking the regulatory hurdles — something their prices do not correctly reflect.
But now, now we find ourselves facing inflation. What’s interesting is that inflation is something we’ve been ‘looking for’ for years, and in Japan, for decades.
As recently as last year, the chair of the Federal Reserve (the Fed), Jay Powell was talking about letting inflation run hot in the near term to get the average rate back up.
Well, we have gotten what we wanted. Through a combination of massive monetary debasement, Covid-19, supply chain issues, geopolitically enforced nearshoring, and a desperate bid to slow carbon emissions... inflation is here.
As we can see from the various investment bank commentators, we see a huge split on expectations for interest rates. The bond market is telling us little will happen, the 5Y5Y ILS rate (a widely used measure of longer‑term market‑based inflation expectations) is telling us little will happen, but the Fed and, at the extreme end, JP Morgan and Goldman Sachs are telling us we need to hike more quickly to get this inflation under control.
Central banks are fractured in their response. The Bank of England has left port, with two consecutive hikes — likely driven by a knowledge that post-Brexit sterling could be in for a rough ride if too closely tied to other bigger currencies. The Fed is due to ‘launch’ next month, and the European Central Bank having been stuck in the traps, has now said it too will start to tighten in 2022.
Well, it depends. Is inflation exploding as most commentators believe? If is exploding, central banks are already way behind the curve, and this will lead to large political pressures as wage growth will lag the cost of goods, and people will start to feel poor.
This belief might well lead to central banks following Goldman Sachs advice to speed up the hikes, either via jawboning or action.
A quick series of rate hikes could be devastating for risk assets. For 10 years we’ve been on Easy Street, but for over 20 we’ve lived with a Fed "put": an implicit knowledge that the Fed wouldn't allow ‘too much pain’.
That put might now need to be repriced. We might need to see a large correction in equity markets, as risk resets.
Growth to value, long duration to short, high yield to investment-grade bonds, investment-grade bonds to sovereign and gold. Assets will flow to safety quickly and in a disorderly manner. Credit markets that have been intermittently creaking with liquidity issues, will come under tremendous strain.
Is the Fed is trapped on this angle? It cannot run hot, the ship would go down as the floating device of trust finally bursts and the financial mirage is laid bare. However, it's not clear that the Fed knows this, or that the politicos know this, so we might need to prove it.
This is the base case: that the Fed talks up action to counter inflation and this talk causes some painful ruptures in asset prices, forcing a reversal.
The alternate path is that the Fed never gets a chance, as with growth seeming to slow, the spectre of stagflation rises again, causing indecision and a need to maintain support.
These are wildly different paths, but they lead to three conclusions: