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The Biggest Tail Risk in Markets Has Shifted

21 May 2021 | Economic News
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The Biggest Tail Risk in Markets Has Shifted

With belief in an inflationary boom now the consensus, the key danger is that the Fed will move too late.

It is the interest in inflation from investors and other consumers of financial journalism that prompts people like me to write more about it; we have the perfect example of reflexivity, in which perceptions can change reality.

Beautiful evidence that the current preoccupation with inflation doesn’t just come from journalists appears in the latest monthly Fund Managers Survey from BofA Securities Inc. Belief in an inflationary boom is its highest since the survey started:

For the time being, hopes are still pinned on a combination of higher inflation and growth, which is infinitely preferable to stagflation. Rising prices would create new challenges for money managers, but economic expansion would ensure that they aren’t insuperable.

However, there is an important sign of a shift in perceptions. BofA regularly asks fund managers what they perceive to be the greatest “tail risks.” For most of last year, the pandemic was the biggest concern. In March, this had moved on to fear of a taper tantrum. In other words, investors fretted that the Federal Reserve would try to tighten monetary policy too early, and trigger a swift rise in interest rates that brings down the stock market and other risk assets such as emerging market currencies. This is what happened in 2013. Now, however, that has changed. The greatest tail risk is that the Fed moves too late, not too early, and fails to stop inflation from taking hold:

Inflation itself, then, really is beginning to create some concerns. But is there genuine evidence of a clear and present danger? That was one of the first questions asked in the Top Live blog, whose transcript you can find here. Commodity price increases are widely cited as one of the clearest signs of inflationary pressure, but they are also widely dismissed as a symptom of temporary or “transitory” bottlenecks in supply as the economy returns to full strength after the pandemic. Further, there are very low base effects when making comparisons with 12 months ago, which is why the year-on-year rise in Bloomberg’s broad commodities index is its highest in many decades:

The commodities that have created the most excitement among investors are those tied to the big macro themes. People want to invest in strength in construction (through lumber or steel) and manufacturing (through lithium and cobalt). Industrial metals, such as copper and aluminum have been aided by both effects.

Beyond that, though, the rise of the electric vehicle does raise the possibility that the materials we most want over the next few years will have to rise in price. The boom in green technologies is great for metals like copper, aluminum, cobalt and lithium, while it also prompts bearishness about oil in the medium-term; although so far that bearishness is mostly expressed in the price of stocks in oil companies, rather than in the price of the commodity itself.

My favorite example of this ultimate perverse reaction came in 2011, when Standard & Poor’s began to consider whether the U.S. should keep its AAA credit rating. After the financial crisis and the stimulus applied by the Obama administration, there was ample reason to doubt this. Naturally, a lower credit rating means higher risk of not receiving your interest payments, and should prompt investors to demand a higher yield.

The following chart shows what in fact happened to 10-year yields throughout 2011. The three vertical lines show the point in April when S&P said that it was putting the U.S. on CreditWatch, then the date in July when the U.S. was placed on 90-day CreditWatch with a view to a possible downgrade to AA+, and the date in August when that threat was carried out. After all three of these negative events, the Treasury yield fell.

When risk increases, investors dive for the cover of Treasuries — and that is true even if Treasuries are the source of the increasing risk. That could place a limit on the chance of a true tantrum. However, Lisa suggests that it might not work that way again, as investors are tending to jettison the traditional notion of a portfolio of 60% stocks and 40% bonds, on the theory that both could do badly if inflation returns.

It’s also not clear that inflation is such a bad thing, given the weight of outstanding debt in the economy. It is arguably the least painful, and also the most politically palatable, way to clamber out from under a huge debt burden.

If bond prices were to shoot higher, then there would be a risk of an equity selloff. The rate at which yields rise can be as dangerous as the level they reach. A swift move upward is perilous. If there is a level that is dangerous, then the adventures of Jerome Powell in 2018, his first year as chairman of the Fed, might be instructive. The year began with the Trump corporate tax cut, which was a big shot in the arm for the equity market. For a while, stocks and bond yields rose in tandem. The moment when equities seemed unable to deal with rising bond yields any more came when the real 10-year yield topped 1%, in the first week of October. It spent about three months at that level, during which time, the stock market suffered a severe selloff:

But it seems to me that the fund managers who told BofA they were now more worried the Fed could leave it too late rather than act too soon were probably right. With plenty of reasonable explanations for why the inflation we have seen so far could prove transitory, it’s best to take the Fed at its word and assume that it will keep rates low in an attempt to spark more. The greatest risk at present, it seems to me, is that they succeed not wisely, but too well.

Reference: Bloomberg

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The Biggest Tail Risk in Markets Has Shifted