Midweek Market Watch: Inflation, Yields And The Risk Of An Overheated Economy

By Stephen Innes, Chief Global Market Strategist at Axi

With the acceleration of the vaccine roll-outs globally and a sharp reduction in Covid-19 infections in the US that seems to have occurred much faster than any prior waves, the most likely scenario is still for a steep economic recovery starting in spring or early summer with heightened over-heating risks.

If the US Federal Reserve wants to overheat the economy, there is an excellent chance those wishes will come true. Chair Jerome Powell has done a superbly effective job in communicating an entirely dovish message and successfully shepherding FOMC members around it – at least for now.

On the political side, US President Biden’s incentives look fully aligned with getting the US economy and populations as healthy as possible ahead of the 2022 mid-term elections.

If both fiscal and monetary policy makes maximum efforts into a post-pandemic recovery, then at the very least we will get temporary inflation along with plenty of debate whether it might become more permanent.

Asian equities have a complicated relationship with bonds. The correlations between rising bond yields, steepening yield curves, and real yields swing around over time. Generally, increasing nominal yields have been positive for equities, while rising real yields slightly negative.

But the stability in bond yields so far is marching to a different reflation drummer and a far cry from the 2013 tantrum. We will find out a bit more regarding the Fed policy. Still, I suspect Chair Powell and company will be ok with another 15-25 bps this year before they need to step in. And I guess yields might fall first before they rise again, as breakevens may make one last climb higher. 

To fall a magnitude 10 destabilising bond sell-off, the market has to re-rate higher either the Fed’s terminal rate (+2.5 %) or the term premium proportion, which has a broader global impact. With the Fed putting up a tent in the yield curve control corner anchoring the front end, so for the near and medium-term, the question is only how the back end will fare against a tape of robust growth and inflation prints.

Unless inflation convinces the market that the Fed will have to adjust its projected landing rate much higher, further upside in nominal 10-year yields should be limited to 30-40 bps this year.

If inflation is perceived to be an issue, the Fed would probably have to react to it one way or another. The most apparent tool would be by raising fed funds quicker than it would otherwise. But the markets are not pricing in a rate hike through at least until 2023.

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