George Orwell once said of the social hierarchy: “All animals are equal, but some animals are more equal than others.” This is also true for financial markets, some markets being more important than others.
So what makes a market important?
Size obviously matters, but it’s not the only factor. For example, the currency market, by far the largest market in the world (with a daily turnover of $ 4 trillion), is generally a follower rather than a leader in terms of its relationship to other markets.
As a macro investment strategist, I value the content of information more than anything else. For me, the most important markets are the ones that best help me decipher the larger narrative and consensus inherent in asset prices.
With so much attention right now on what the Fed will face on the upside, I’m following the US inflation-linked government bond market more closely than any other. All you need to know about this market is that when you buy an inflation-linked bond, the coupons you get are the product of “real returns” plus real inflation at the time of payment dates. coupons.
There are four reasons why real long-term U.S. government bond yields are so important to global financial markets:
- The pricing of all financial assets requires a risk-free rate, the return on a risk-free asset.
- Valuing assets with long-term cash flow requires a long-term risk-free rate.
- Since investors are only interested in real returns (after inflation), they only care about the real risk-free rate.
- Given the size of the US markets and the reserve currency status of the, the long-term US real risk-free rate is often accepted as the long-term real risk-free rate for the world.
Since monetary policy works through long-term interest rates and real interest rates, real long-term government bond yields tell us a lot about whether the market s ‘expects future monetary policy to be loose or restrictive.
Judging by the fact that the US 10-year real yield (the real yield on a 10-year inflation-linked government bond) is currently minus 1.1%, not far from its low. history (see chart below), we can safely say that the market thinks the Federal Reserve will keep monetary policy very loose as far as the eye can see.
This is the reason why investors bought stocks hand in hand. They assume the punch bowl won’t be swept away anytime soon.
But what about inflation? Doesn’t the market know that consumer price inflation hit a 30-year high last month (6.2%)?
There is a saying on Wall Street: “Don’t fight the Fed. This means that you are not guessing the US central bank, you are accepting what it tells you. And right now, the Fed is telling us that inflation will be “transient” (the code word for “No Need to Act”).
Below are the three most important takeaways from Federal Reserve Chairman Jerome Powell last week:
- “The inflation we’re seeing is really not due to a tight labor market.
- “We don’t see worrying wage increases, and we don’t expect them to emerge.”
- “There is still some way to go to achieve as many jobs as possible, both in terms of employment and in terms of participation.
Since peak employment is one of the Fed’s two mandates, Powell is essentially saying he’s in no rush to raise interest rates.
It makes no difference to the market that what Powell said is not backed up by the data. grew to 4.9%, the highest in twenty years (see graph below). Unit labor costs are increasing at a rate of 4%, the highest in thirty years. The number of companies reporting vacancies as difficult to fill is at an all time high.
Having watched the Fed for twenty years while working on Wall Street, I learned that the central bank is neither infallible nor that their policies are infallible.
However, what Powell has said is so out of touch with reality that I cannot believe his statements stem from sheer ignorance. Could there be another reason for his incredible complacency?
Well, it turns out Powell’s term will end in two months, and US President Joseph Biden is set to announce his nomination for the next Fed chairman overnight. What if Powell had decided that in order to get a second term he had to convince the President of the United States that he would do nothing to ruin the party? Is it possible that he is actually less accommodating than he seems?
I suspect that another factor behind the current extremely low long-term real returns is the market’s expectation that Lael Brainard, a super dove backed by the progressive wing of the Democratic Party, has a decent chance of taking the job. the highest from the Fed.
The bottom line: The immediate outlook for real returns and for the stock market hinges on who Biden will appoint the next Federal Reserve chairman.
Who will Biden go with? In my opinion, the answer is quite simple.
Biden faces huge challenges at home and abroad. His party just lost a huge election in Virginia; his social spending bill is in trouble; its negotiations with Iran are blocked; his call for the Saudis last week to increase oil production fell on deaf ears.
In my opinion, Biden needs someone who can go through the Senate confirmation process smoothly. Right now, Powell has much stronger bipartisan support than Brainard in a 50/50 Senate.
So yeah, I think Biden will name Powell. If I’m right, we should see real returns increase.
Given the recent correlation pattern between real returns and other markets, I recommended my blog subscribers to short the iShares TIPS Bond (NYSE 🙂 ETF, buy the USD, and purchase through the iPath® Series B S&P 500® VIX Short-Term Futures ™ ETN (NYSE :).
These trades are not for the novice or for the faint-hearted. For them, I would suggest being very cautious in the coming weeks due to the increased risk of repricing long-term risk-free rates.
If I’m right, will outperform and outperform. And the cash will surpass everything else.