U.S. Treasury Secretary Janet Yellen (L) and Federal Reserve Board Chairman Jerome Powell (R) testify during a hearing before Senate Banking, Housing and Urban Affairs Committee on Capitol Hill November 30, 2021 in Washington, DC.
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Federal Reserve Chairman Jerome Powell’s retirement of the term “transitory” to describe inflation could have an unexpectedly bleak knock-on effect on risk assets, according to Cole Smead, president and portfolio manager at Smead Capital Management.
Powell surprised markets earlier this week by altering his previously consistent tone on inflation, telling U.S. lawmakers that “it’s probably a good time to retire that word (transitory) and try to explain more clearly what we mean.”
Inflation has begun to consistently exceed central bank targets, prompting increased speculation that central banks could be forced to tighten monetary policy earlier than expected. Investors have been trying to ascertain where and how the Fed might look to tackle inflation if it concedes that rising prices are stickier than expected.
Speaking to CNBC’s “Squawk Box Europe” on Thursday, Smead said Powell’s comments amounted to a “mea culpa,” or an admission that he was wrong, and that the potential effect it could have on Fed policy and the value of assets might be underappreciated.
“In effect, people are buying the 10-year (U.S. Treasury note) feeling insulated on the longer end of the curve, but the reality is no asset will benefit from the cost of capital rising, and you can kind of see the same thing going on in certain U.S. equities,” Smead said.
“Most equities have been punished the last couple of days, and we can talk about the omicron [Covid variant], but I really think it’s people somewhat fearful of the Fed’s pivot to being wrong.”
Smead suggested that people buying “quality blue chip businesses” typically considered longer duration investments, such as Microsoft and Apple, looked “just as foolish as buying the 10-year right now.”
The yield curve shows the relationship between short-term and long-term interest rates of U.S. Treasury notes. Usually, the longer the duration, the higher the interest rate, but when the rates draw closer to one another, the yield curve flattens. An inversion of the curve is typically seen as a warning signal for the market.
The yield curve has flattened this week, with long-dated bonds nearing their lowest point for a year on Thursday, as investors speculated that early rate hikes from the Fed could curtail spiraling inflation. Yields move inversely to prices.
This comes despite strong jobs numbers and PMI (purchasing managers’ index) readings out of the U.S., indicating that the economic recovery is still on course.
Smead attributed this to investors “looking for somewhere to hide in the interim” as Powell’s shift in tone falls outside investors’ expectations.
“They’ve treated the Fed as though they were an omnipotent ship captain and as long as the captain stewarded the ship, you were going to be fine, which was really nothing more than ultimate liquidity,” Smead said.
“Now that liquidity is going to be gone, the question is how quickly and how much, and I just don’t think people know what that’s going to be like.”
He argued that the U.S. consumer is seeing “incredible inflationary pressures,” and real yields — interest rates adjusted to remove inflation, therefore representing the real cost of capital to the borrower and the true yield to the lender or investor — are going to spike if the Fed tightens.
“We’re going to watch real yields go from the most negative levels we’ve seen since like 1974 to a meaningful real yield, and that is catastrophic for risk assets,” Smead concluded.
‘Much further upside’
Not everyone shares Smead’s bearish view, however. In a briefing to journalists in London on Thursday, JPMorgan Head of Global Equity Strategy Mislav Matejka said the Fed was just giving itself flexibility, keeping liquidity on the table while accelerating tapering to ensure that it is not “behind the curve.”
“To be bearish on equity markets you need to assume the central bank will be focusing fully on inflation and away from growth, and that’s not what usually makes you money,” Matejka said.
“Usually, central banks are there as a put option for the equity markets; they are there to support if there is a loss of liquidity or if there is a shock. To argue in the developed markets that central banks will drive the equity market weakness next year, that’s not what happens all that many times historically.”
JPMorgan’s view is that with headline inflation at multi-decade highs in many major economies, the peak will have come and gone by the second half of 2022, making the Fed much more comfortable with the pace of winding down its stimulus package.
Matejka noted that key indicators of stickier inflation, such as thermal coal prices in China and the Baltic freight index, are “already rolling over.”
“In three to six months’ time, the question is ‘will the Fed really need to turn ever more hawkish relative to what the market is already pricing?’ The market is already pricing, right now, almost three hikes by the end of next year,” he said.
The upshot, Matejka said, is that the bear case only comes to pass if markets decide the Fed is making a policy mistake by tightening “no matter what,” even in the face of disappointing growth.
However, JPMorgan believes growth is going to be stronger than consensus expectations in 2022, and the market has already priced in its concerns over the past six months, as evidenced by flattening yield curves.
“That actually could be easing because the market actually starts to realize central banks in the developed markets, the key to Fed and ECB, might not need to move ever more increasingly hawkish, and that allows the equity markets in our view to have much further upside,” Matejka said.