Over the last month, we’ve witnessed market expectations change. Inflation in 2021 is no longer beyond belief. And many have come around to the idea that, Covid-19 aside, 2016 marked the end of the 40-year bull market and the cyclical low in inflation.
There have been several signs for this. For example, PPI not only shows inflation, but right now signals it could go further. While this would likely lead to further damage to bonds, the speed of the recent decline suggests bonds are due for a bout of consolidation, which could easily run for a few months.
The waves of inflation change
The boat has been rocked by the first wave of inflation anticipation. But we fear the estimates of what’s to come are still too low, and a repricing could ripple across fixed income. When looking at ten-year US Treasury yields, we can see they have reached and exceeded key levels. US 10-year bond yields, for example, hit 1.75 per cent, and mortgage rates are sailing upwards.
Our models suggest inflation will spike far higher and prove less transitory than currently discounted. What’s more, we’re likely to have an infrastructure bill by the end of this year, and there are already whispers of further spending ahead of the 2022 midterm elections to prevent a fiscal cliff. This wave has the potential to be a tsunami.
All hands on deck for Triffin’s Dilemma
The captain of this ship is the Federal Reserve, and they are tasked with navigating through inflationary waters. Typically, the Fed would choose between hiking or potentially losing control of the bond markets. But with Triffin’s Dilemma, it’s not so simple. This catch-22 moment only occurs when the world’s reserve provider pursues domestic policies which are incompatible with its status as the reserve currency. We got a taste of this dilemma when Trump’s 2017 procycical bonanza spurred the Fed to tighten policy, leading to a much stronger dollar and a slew of problems in global markets.
Navigating the impossible trinity
But the notion of Triffin’s Dilemma is made worse by the impossible trinity. This idea most commonly comes into play in the context of a currency peg. Here, having decided to peg a currency, the central bank must choose whether to control money supply or domestic interest rates. It cannot do both. We’ve seen this over and over again, with the net result often being that money supply growth can see some wild swings.
Now, with Treasuries threatening to throw a tantrum, the Fed faces the trilemma of whether to let the bond market, equities or the dollar sink slowly below the surface. This is the equivalent of the ship going down and only being able to save two things, when all three are crying out for help.
Sink or swim – market implications
From Australia to Europe, central banks have been forced to intervene to prevent their own bond markets from following Treasuries into freefall. The good news is that, thus far, the Fed is also pushing back forcefully. As a result, the fallout has been contained, and yet another destructive dollar rally has seemingly been averted.
However, the pricing disparities between markets will continue. Stocks, bonds, and the dollar have reached an unsustainable balance, and something has to give. Quite simply, with inflation set to accelerate much further than priced, bonds are vulnerable to a sharp selloff which in turn can affect stock prices. Alternatively, the Fed may opt to pick stocks and bonds over the dollar, allowing it to weaken to take the strain. After all, the dollar is not the bailiwick of the Fed but rather that of the US Treasury Department.
We are watching the Fed closely. There is certainly room for dollar strengthening on the back of rate differentials and improved Covid-19 outlook. But as we look to the horizon it is clear that inflationary tides are sending us towards Scylla and Charybdis, and lest they want a bond rout or equity dump, the Fed may be forced to plug its ears to a dollar decline.