Investors too sanguine about inflation risk

Nasdaq 100 entered a technical bull market this week

Tom Eckett

US dollar inflation

The message was clear from ETF Stream’s ETF Buyer: Zurich event last week. Do not try to be a hero in this market environment.

Investors are currently too focused on the banking crisis and not on inflation, something which is clearly baffling Federal Reserve chair Jerome Powell.

After last week’s Federal Open Market Committee meeting, Powell baulked at the idea of a cut this year.

"Given our outlook, I just do not see us cutting rates this year,” Powell said last Wednesday after the Fed hiked rates by a further 25 basis points (bps).

‘Do not fight the Fed’ is an adage often thrown around by commentators on Wall Street, however, the market is calling the Fed’s bluff amid a banking crunch that is evoking memories of the Global Financial Crisis (GFC) in 2008.

According to the CME FedWatch Tool, markets are forecasting a 34.7% chance the Fed will cut rates by 25 basis points (bps) in July’s Federal Open Market Committee (FOMC) meeting while there is only a 7.3% chance the Fed will not lower rates by the end of the year, as at 29 March.

Fears of contagion risk in the banking sector is keeping the market’s outlook for interest rates this year at lower levels than the Fed is forecasting.

The theory is a slowdown in the US economy will force the Fed to cut rates at a faster pace, especially if inflation continues to fall towards the central bank’s 2% target.

However, investors are significantly underestimating the risks of inflation remaining stickier than current market expectations, according to Jim Masturzo, CIO, multi-asset strategies at Research Affiliates.

“Elevated inflation has caught the market by surprise,” Masturzo said at ETF Buyer: Zurich. “While likely to moderate, inflation is poised to run higher than the last decade.”

His views were echoed by Roman Mayer, global head of fund advisory at Union Bancaire Privée, who warned the financial system is on “thin ice” while stressing the importance of remaining diversified.

Jonathan Duensing, head of US fixed income at Amundi, added: “Powell’s comments confirmed that the Fed is very likely close to the peak in its rate cycle but he clearly did not endorse the rate cuts currently priced into the market.

“Therefore, we remain sceptical that the Fed will cut rates as early as June.”

While the sell-off in bank stocks represents a potential buying opportunity, as I wrote last week, there are very few options for investors in the current market environment if inflation remains sticky.

As a result, short-duration US Treasuries and Treasury Inflation-Protected Securities (TIPS) are attractive defensive plays with any additional duration a risky move in this scenario.

“The worry I have is that policy is still not tight enough to completely tame inflation organically but starting to get too tight to avoid accidents,” Jim Reid, head of global fundamental credit strategy at Deutsche Bank, said.

With the Fed walking a tightrope, investors will need to be more patient until there are clearer signals to start adding risk to portfolios.


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