Biden, Yellen and Powell drive the new paradigm on growth & inflation. It’s up to the markets to adapt.

Published on March, 23th 2021 Market and research
Winter in... Coming?
Stéphanie Bigou

Stéphanie BIGOU

Portfolio Manager

Written by Stéphanie Bigou, Global Macro fund manager at Seeyond, 10th March, 2021

Biden, Yellen and Powell drive the new paradigm on growth & inflation. It’s up to the markets to adapt.

  • The Biden administration and the Fed, want to enhance the US growth based on robust household demand and solid private investment.
  • They need inflation to achieve their goal. The Fed will prevent sharp increases in real interest rates.
  • Inflation will recover more gradually than investors fear. The Fed should not taper in the near-term.
  • This scenario is good for equities, credit and and reflation trades.

From AMERICA FIRST to AMERICANS FIRST

The United States never really recovered from the Great Financial Crisis of 2008. Certainly, the equity markets are at their all-time high and the unemployment rate fell to its lowest level since the end of the 60’s in late 2019, but these figures mask deep social inequalities, an increase in precarity and an impoverishing middle class.

  • With 61.4%, the participation rate is at its lowest level since mid-70’s. The decline accelerated in 2008 after the shock induced by the GFC, a sign that a portion of the US population is not returning into the workforce.
  • The gap between the richest and the poorest has never been so high with an acceleration since the GFC (chart 1) with the poorest becoming poorer and the richest becoming richer.
  • Overall, American household wealth has declined since 2008. In 2016, the median wealth of all US households was $97,300, up 16% from 2013 but well below median wealth before the recession began in late 2007 ($139,700). (source: pewresearch.org, figures adjusted for the USD evolution)

   Chart 1 – Wealth shares in the US – 1962 – 2016 – Source : NBER, Inequality.org, Seeyond

Wealth shares in the US

This situation is troublesome for several reasons:

  • It is a major source of political and social instability.
  • It is a source of macroeconomic volatility as the middle class no longer serves as a shock absorber in the event of a recession, increasing its use of the debt, which could become unsustainable in the long term.
  • It makes the country more dependent on external growth, which is problematic in an environment of deglobalization.

By winning the presidential elections last November, the democrats made a promise to Americans: restore social peace in a deeply divided America. To do so, Biden, Yellen and Powell have a mission: put an end to nearly 25 years of deflation that have lowered US households purchasing power, deepened social inequalities and exacerbated tensions between communities.

To achieve this goal, they have three tools:

  1. a huge Keynesian fiscal package,
  2. a huge Investment plan in Infrastructure and the Sectors of the future,
  3. a huge and unorthodox Monetary support based on Average Inflation Targeting.

The idea is to create a significant shock on growth to enhance the country’s potential growth, as wages will structurally and gradually benefit from increasing household demand and the development of new promising sectors of activity.

WHAT DOES IT MEAN IN TERMS OF INFLATION?

This new paradigm is close to the notion that some economists call the optimal rate of investment linked to the optimal rate of inflation (Revue Economique, Xavier Ragot 2004). Under this theory, monetary authorities can achieve the optimal level of investment through a monetary policy that creates long-term inflation. Indeed, a positive level of inflation contributes to a decrease real interest rate over the long-term. Some studies, under some hypothesis, tend to show that the optimal inflation rate could be between 3 and 4%.

Indeed, if inflation driven by stagflation is negative for the economy, some good inflation is needed to stimulate household demand and the corporate sector.

Inflation driven by a positive shock on growth is positive:

  • For the Households, as increasing inflation expectations will stimulate wage negotiations and increases demand for goods and services today rather than tomorrow.
  • For the Corporate sector, as perspectives of increasing demand and public investment will stimulate private investment.
  • For Governments, as inflation will erode debt while increasing tax revenues.
  • For the Authorities, as a gradual and moderate increase in interest rates is likely to attract new investors to finance fiscal plans.
  • For the Financial sector, as steepening yield curves will increase its profitability.

Inflation is a problem when input prices increase more than the demand, and pricing power declines, preventing any pass through of input prices into output prices.

What does it mean to the Fed?

We believe, Powell will let good inflation slip away on the short to medium term to create a positive inflationary spiral on both wages and investment. He shouldn’t modify his bias and the size of the Fed balance sheet till signs and risks of deflation have not definitely disappeared.

The Fed needs:

  • increasing nominal interest rates to attract new investors to respond positively to bond issuance,
  • yield curve steepening to stimulate the credit offer,
  • attractive real interest rates to avoid an excessive increase in default rates.

Therefore, it seems that there is no other solution than to taper late in the cycle and gradually. If long-term interest rates are to rise, the Fed will closely monitor the pace of appreciation and will be patient before raising the federal funds rates. In the meantime, inflation will have increased, maybe above 2%.

No imminent change in the monetary policy despite a gradual increase in inflation means that real interest rates shouldn’t increase too much and will remain attractive. Reflation doesn’t mean either stagflation, or hyperinflation. Reflation is a sign that stimulus packages are starting to work and marks the beginning of a new cycle.

  

WHERE ARE WE IN TERMS OF INFLATION TODAY?

Visibility on inflation is limited as many indicators tend to send contradictory signals.

  • Price components of confidence indicators (Manufacturing and Service ISM) and raw materials markets are pointing to a sharp increase in inflation on the very short run, mainly on the headline figures.

But :

  • The Chinese credit impulse is fading and could dampen the rise in commodity prices.
  • US labor market data such as job creations are more cautious regarding inflation on a medium run perspective (chart 2). Job destructions have been considerable, and the gap should take many months to close.
  • US capacities of production (chart 3) are too high to anticipate a sudden surge in inflationary pressures.

We think these doubts will persist for a while and will prevent any imminent change in the monetary policy. The Fed won’t take the risk to jeopardize the recovery by tapering too soon as it did in 2013.

Chart 2 – Inflationary pressures and US Job creation – January 2000 – February 2021 – Source : Bloomberg, Seeyond

Inflationary pressures and US Job creation

 Chart 3 – Inflationary pressures and US Capacities – January 2000 – February 2021 – Source : Bloomberg, Seeyond

Inflationary pressures and US Capacities

If the Fed is cautious regarding inflation on the medium term, what about the markets?

US nominal 10-year interest rates increased sharply recently, and so did the US 10-year breakeven yields (*), pointing to a sharp increase in inflation on the short run.  However, the message is different when we increase the horizon. The slope of the breakeven yields curve is in a negative territory since January 2021, and its dynamics (chart 4) suggests that inflation could temporarily exceed 2%, and then fall again below at least till the end of the year, requiring no immediate change in the monetary support. 

* a measure of the difference between the Treasury rates and the yields of the TIPS (Treasury Inflation-protected Securities)

Chart 4 – Medium term Inflation expectations & Core Inflation – January 2010 – February 2021 – Source : Bloomberg, Seeyond

Medium term Inflation expectations & Core Inflation

In a nutshell, both the Fed and the markets agree. Inflation will increase as economies reflate, but definitely more gradually that some investors fear. Yes, inflation is increasing, but the current level cannot justify any tapering from the Fed and its new philosophy. While long term interest rates should increase, the pace of the increase should slow down and could even be temporarily reversed (as new interest from investors could also emerge due to current levels of interest rates close to dividend yields). This scenario remains favorable to equities, credit, reflation trades and structurally negative for the US dollar.

Key points for markets

Will US nominal interest rates increase till the end of the year?
Yes, we think so.

Will US nominal interest rates increase in such amplitude and such speed, as recently?
No, we don’t think so.

Will US inflation increase till the end of the year?
Yes, we think so.

Will US inflation increase in such a way that the Fed will taper very soon?
No, we don’t think so.

Reflation will take time. Breakeven bond market already realized the reality of the current moderated inflationary pressures.

Stock market, whose horizon has been shortened by the massive liquidity inflows, should follow suit soon. Investors have forgotten how to deal with inflation over the last decades and fear rate hikes. They need to be re-educated!

This article has been provided for information purposes only to professional clients as defined in the MiFID Directive. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in his article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks, and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.