Inflation And The FED – The Key To US Markets In 2021

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Chris Weston
Chris Weston

Inflation remains the hot-topic for anyone forecasting the US recovery in 2021. In his recent analysis, Chris Weston, Head of Research at Pepperstone, highlights a number of key indicators to watch, and how FED policy will be crucial to traders in the latter half of 2021. Read a summary of his thoughts here:

Inflation

The topic of inflation continues to be eagerly debated and rightly so as the Fed knows there’s a debt overhang and the only way they’re possibly going to get out of this is to inflate the debt away.

That means pitting monetary policy alongside fiscal to create a red-hot economy and nominal levels of GDP north of 6%. The real optimists would hope that we get such compelling levels of aggregate demand and a reduction in the output gap that wages, low and behold, increase.

That would get the inflation hawks talking.

However, should the market sense that the velocity of money is reversing as the US economy opens up and pent-up demand kicks in, and more USDs will be turned over more frequently, then that would be a huge development.

The risk of being long US Treasuries if the market sees the velocity of money turning higher is clear and this is where funds pile on short-duration positions and we see yields in 10s moving towards 1.50% by Q3/Q4.

Bond Markets

Near-term we’ve seen a better bid emerge in bond markets.

US 10-year Treasury yields coming in from 1.185% to 1.085%, 10-year breakeven rates have pulled back to 2.08% and could possibly pull back to the 2% level as real-time economic data starts to moderate.

However, once we get past this stage though and the vaccine effort improves then things get interesting.

Let’s not forget that the Fed are the biggest buyers of both US Treasuries and TIPS (Treasury Inflation-Protected Securities) and the difference between the two is the breakeven inflation rate – so in essence, one of the key measures for expected inflation is largely controlled by the Fed.

Then recall that inflation expectations typically lead to actual inflation.

So big change is coming, but what are the trigger points? One might be the tine of the FED.

The Fed’s reaction function has slowed under its new regime of average Inflation targeting.

They are more evidence-based and want to see it before they believe it. Whereas, in prior cycles such as late 2018, their pro-active stance caused them to hike earlier. It’s for this reason why this week’s FOMC meeting will be an extension of the recent dovish narrative that they are in no rush to move policy.

My best guess is the Fed’s language will not materially change until April once we see fiscal stimulus, the economy starts to heat up and the vaccine efforts are more efficient.

It’s at this point that I see a real risk that US Treasuries sell-off, yields curves steepen and inflation expectations rise.

Conclusions

While we could be in for a short-term period of uncertainty, which could lead to a higher USD, the road for the year ahead screams of growth and inflation and that’s the camp that I sit in. How the Fed deal with the bond market will be key.

Read the full piece here.