The good news and the not so good news
Do you want the good news or the bad news? The good news is that the headline year-on-year inflation rate continues to fall in America. Good news, at least for the consumer, for stocks, that may be the bad news. The Fed signalled last week that they have no plans to raise interest rates much further, but it sees no reason to cut interest rates any time soon as it continues the fight against inflation. The playbook they may be using goes back 50 years, when the Fed thought they had won the inflation battle in the 70s, cut interest rates, only to see prices rise again. It was not until the ’80s, when Paul Volker induced an economic recession that inflation was finally tamed.
The bond market continues to expect the Fed to start cutting rates at some point this year, despite the Fed’s stated stance. The only thing that may change the Fed’s mind is an economic recession, so is that what the bond market is starting to price in? The equity market currently appears to be taking the view any downturn will be mild as the consumer and employment levels will prevent a hard landing; that is also Powell’s take. The bond market appears less optimistic.
If the Fed sticks to its stated plan of not cutting rates this year, which means the equity market is correct and any economic downturn is mild, inflation rates are likely to fall closer to the 2% target. That makes bond markets more attractive as negative rates become real interest rates, and equity valuations come under pressure as the risk premium will narrow. Stocks would need to adjust, or earnings need to rise.
So what is the good news? The good news is that this must be the best prepared for a bear market in history. The phrase finding a bull in a china shop comes to mind, or anywhere for that matter. Fund managers are liquid, and those who do not prefer bonds to equities. The Vix is trading well below its historic average despite our uncertain climate. This can suggest either complacency or that investors already feel well protected against any downturn and have no need for further insurance. For now, that all leaves equity markets in limbo, as they have been for some time.
Turning to the Bank of England on Thursday, they duly raised rates by 25 basis points, as expected by a 7 out of 9 majority. Weirdly they justify the increase in interest rates, blaming the food producers for increasing prices as the reason for the rate rise. Not sure higher interest rates translates through into people eating less.
Recent China economic data can be described as mixed at best. As the developed world struggles with bringing inflation rates down, China seems to have the opposite problem: year-on-year inflation announced this week is just 0.1%. That does leave plenty of room for the government to stimulate the faltering economy. Whether you want to stimulate a credit bubble further is another matter.