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Vince Foster: Inflation Risk Is Back, and Investors Need to Prepare for a Bumpy Ride


With the Fed continuing to reduce stimulus, markets had been anticipating an eventual exit and thus lowering inflation risk premiums. After the Fed's press conference last week, that all changed.

On June 9, in As ECB and Fed Policies Diverge, It's Time to Weatherproof Your Portfolio, I suggested monetary policy error risk was growing and that investors should seek exposure to inflation risk: 

In the current environment the expectation for growth is high and inflation is low. It's truly a Goldilocks scenario. However with unprecedented central bank action, is this scenario sustainable? Inflation is low by historical standards, but so is growth. The slightest shock from such a low base can have a magnified impact on the economy. There is not much room for error.
The Fed has a very delicate task. Move too slowly and rising inflation risk could crush aggregate demand. Move too quickly and it risks creating a liquidity vacuum that sucks the fuel out of the financial system. Instead of assuming they walk the tightrope, I think this is a time investors should assume policy error risk is high and look for exposure to risk in both tails.
Well it didn't take long. Inflation risk is back on investors' radars. I don't mean actual inflation risk -- that's been building all year in commodity prices; I mean rising inflation risk premiums. With the Fed continuing to reduce stimulus, markets had been anticipating an eventual exit and thus lowering inflation risk premiums that have been so prevalent under QE. However at Wednesday's post-FOMC press conference Chairwoman Yellen made it clear that the Fed was in no rush to tighten. She said the following:

Based on its current assessment of these factors, the committee anticipates that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the committee's 2% longer-run goal and longer-term inflation expectations remain well-anchored. 

Further, once we begin to remove policy accommodation, it's the committee's current assessment that, even after employment and inflation are near mandate consistent levels, economic conditions may for some time warrant keeping the target federal funds rate below levels the committee views as normal in the longer run. This guidance is consistent with the paths for appropriate policy, as reported in the participants' projections, which show the federal funds rate for most participants remaining well below longer-run normal values at the end of 2016. 

Although FOMC participants provide a number of explanations for the federal funds rate target remaining below its longer-run normal level, many cite the residual effects of the financial crisis. These include restrained household spending, reduced credit availability, and diminished expectations for future growth in output and incomes, consistent with the view that the potential growth rate of the economy may be lower for some time. 
Yellen not only made it clear the Fed is going to err on the side of "lower for longer," she flat out lowered the Fed's assessment for the structural growth rate of the economy, and she lowered the terminal policy interest rate. That confirmation has reintroduced investors' appetite for inflation risk premiums. After the initial short covering rally in the long end, it quickly became apparent the bond market would fade duration risk, steepen the yield curve, and favor the inflation protection offered in TIPS.

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As I said Friday on Twitter, the biggest risk to bond yields is not the Fed tightening, it's the Fed not tightening. This is going to become the theme for the second half of the year, and it's not clear how markets will react. Under the exit scenario, investors were able to better price duration risk, and that risk came down via a flattening yield curve. With the Fed on hold for the foreseeable future, that duration risk just became more risky and the markets are going to price accordingly.
Consider what happened to UK yields since June 10, when Bank of England Governor Carney surprised markets by bringing forward the likelihood of rate hikes. Short rates rose but long rates barely moved. The 10-year gilt was at 2.70% and remains at 2.75% today. Policy certainty is bullish for duration risk, even if it's projecting higher interest rates.

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The Fed's policy is anything but certain. In fact, during Yellen's press conference she uttered the word "uncertainty" nine times. The 2016 blue dots projecting the year-end federal funds rate were all over the map ranging from 75bps to 4.25%. How can the committee members be that far apart on projections? This policy uncertainty is likely going to produce inflation risk uncertainty, which is going to produce bond market uncertainty, and that should produce a steeper yield curve.
The committee is uncertain about the economy because they are uncertain how they are going to exit policy. The committee does not yet know how they are going to raise rates.  The Fed can't tell you when because it can't tell you how. As I said before, uncertainty introduces policy-error risk. The Fed says it has the tools, but no one knows how those tools will be used and how markets will react to different tools. This is a recipe for a train wreck.
On May 27, in response to the markets concern about low implied volatility,  I wrote "Implied Volatility Is Low Because Inflation Risk Is Low"and stated: 

I believe one of the biggest contributors to volatility is inflation risk. Inflation risk manifests itself in the value of the dollar, the yield curve, and credit and equity multiples. All else equal, when inflation risk is high, the dollar is weaker, the yield curve is steeper, and credit and equity multiples are wider. When inflation risk is low, the dollar is stronger, the yield curve is flatter, and credit and equity multiples are tighter.
That all changed on Wednesday. Inflation risk is back and that should reintroduce volatility risk to asset prices. The path to exiting stimulus is going to be anything but certain, and investors need to prepare for a bumpy ride.

Twitter: @exantefactor
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