The Growing Disconnect In Financial Markets
There is a divergence in the performance of equities and real yields in bonds. The lag effects of history’s swiftest tightening cycle are only beginning to be felt, but the market has yet to react.
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Disinflation And Monetary Policy
As we delve deeper into 2023, the U.S. economy finds itself at a crossroads. Disinflation seems to be setting in as a direct result of the Federal Reserve’s tightening monetary policies. This policy shift has led to a notable slowdown in the annualized sticky Consumer Price Index (CPI) over recent months. With this in view, the conversation among market participants has gradually shifted away from inflationary concerns and toward trying to understand the impact of the tightest monetary policy in a decade and a half.
The high inflation we’ve experienced, particularly in the core basket (excluding food and energy), concealed the effects of the swiftest tightening cycle in history. Inflation was partially fueled by a tight labor market leading to increased wages, and has thus far resulted in a sustained second-half inflationary impulse driven more by wages than by energy costs.
It’s worth noting that the base effects for year-over-year inflation readings are peaking this month. This could lead to a reacceleration of inflationary readings on a year-over-year basis if wage inflation remains sticky or if energy prices resurge.
Interestingly, real yields — calculated with both trailing 12-month inflation and forward expectations — are at their highest in decades. The contemporary economic landscape is notably different from the 1980s, and current debt levels cannot sustain positive real yields for extended periods without leading to deterioration and potential default.
Historically, major shifts in the market occur during Fed tightening and cutting cycles. These shifts often lead to distress in equity markets after the Fed initiates rate cuts. This isn’t intentional, but rather the side effects from tight monetary policy. Analyzing historical trends can provide valuable insights into potential market movements, especially the two-year yields as a proxy for the average of the next two years of Fed Funds.
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