The Big Picture: Jun 14, 2021

There’s a growing debate amidst the punditry as to whether inflation is transitory and, if so, whether it matters. In an interesting WSJ article yesterday, James Mackintosh notes that “markets are leaving little room for the Fed to be wrong on inflation.”

With stock and bond prices so high relative to historical values, this is undoubtedly true. Mackintosh references Michael Pond, head of global inflation-linked research at Barclays, who recently noted that the Fed was right the last time it bet on inflation being transitory, in 2011. But, it’s important to recognize “why” the Fed was right at that time.

The problem with soaring inflation, of course, is that it can lead to soaring interest rates. Between Jan 2010 and Feb 2011, the 10Y had been averaging a 1.5% spread over CPI. After the Fukushima disaster in March, inflation began to outpace the 10Y — not because inflation rose but because the 10Y plunged due to the disaster and the sharp equity correction which began in July 2011 when US credit was downgraded.

In other words, the equity correction gave interest rates a nudge in the right direction, leading CPI by 7 months at which point the influence of falling oil/gas prices finally began to be felt.  Fukushima and the equity correction produced a sharp decline in interest rates to which inflation eventually “caught down.”

By September, the relationship had flipped and CPI exceeded the 10Y by almost 2% — culminating in a central bank-induced crash in oil/gas prices in 2014-2016. Stocks were protected by the yen carry trade, which central bankers revved up in order to stimulate algorithms to go all-in on stock purchases.

By early 2015, the 10Y was back to a 2% spread over CPI as the oil/gas crash played out. The chart below shows both printed on the same scale.

But, of course, it also illustrates the shocking 3.3% spread between the 10Y and CPI. In Spring 2020, it appeared that the situation would ultimately be rectified by another 2014 or 2018-style crack in oil/gas prices – the point being to keep interest rates from running away from inflation. But, as in 2011-2012, exogenous events did the Fed’s bidding.

The COVID crash crushed interest rates to where the Fed, facing a nearly $30 trillion deficit, would eventually need them. The pandemic also gave the Fed all the ammunition it needed to justify QE so massive that the bond market’s price discovery mechanism was seriously damaged if not destroyed.

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