We got a big CPI print today, 5.0%. That’s above expectations. And, we saw a mild uptick in US Treasury bond yields on the back of the number. But I am wondering whether it really matters. Let me explain.
Yesterday, after posting on the death of the so-called bond vigilantes, I was talking to my friend J. And I told her that, back in February, I had been writing about my concerns regarding inflation expectations becoming unanchored. In our conversation, I referred to these comments:
this [rise in yields] is the market frontrunning the Fed based on expectations about real GDP growth or inflation or both. The market is essentially signalling concerns that nominal GDP is going higher and that yields need to move in that direction to either protect against inflation or because the Fed will act with a lag.
… I am more concerned about inflation this time than I was last time [in 2018]. I don’t think it is a secular issue, but it could be a cyclical one. With commodity prices rising and pent-up demand potentially buoying prices further still once enough people are vaccinated, we could see an even steeper sell off in bonds as inflation expectations rise. I remember being less concerned about that in 2018.
I remember her response being something to the effect: “Does it matter, Ed? At this point, the Fed is signalling it is going to look through inflation and focus on employment. So I’m not sure it does.”
That’s where I am too. Yes, we got a mild uptick in yields on the back of a bad inflation print. But bond markets are telling you they don’t think the Fed’s reaction-function is as inflation-dependent anymore. We’re in a new policy regime. And that matters for rates.
While I continue to believe we will see yield flares in the back half of the year if inflation prints continue to be hot, the pain trade is in the opposite direction, toward lower yields and higher convexity on bad economic data.
That’s one of three outcomes. Another is where an increasing number of people are positioning. You’ve heard Larry Summers and Stephen Roach voice their concerns about the Fed getting behind the curve and being forced to react belatedly — and aggressively. That’s a ‘crash up, crash down scenario’ where yields go up aggressively creating a sudden monetary tightening that ends in the economy stalling and a massive frontrun toward lower yields.
Where we’ve been since Q1 is in the Goldilocks scenario with yields range bound. Policy is neither too hot nor too cold, giving risk assets room to run. I’ve been calling this period The Interregnum though, because we’re likely in a regime shift but it’s not clear how committed the Fed is to that shift of you listen to Roach and Summers.
This is an environment to foster Minskyian stability that breeds instability. But sometime in the Summer to early Fall, the Interregnum will be over. And that’s when we should expect volatility to rise. Enjoy the low volatility while you can.
P.S. – Shout out to the excellent John Authers who picked up on that piece I wrote yesterday. You should read his take. Link here.