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Why the market is wrong again about inflation

Composite image of money and people shopping in a supermarket as inflation hits prices.
There were a myriad of indicators in late 2021 pointing to an unleashing of inflation pressures. (Source: Getty/AAP)

Financial markets were horribly wrong in failing to price in the inflation surge that unwound from the middle of 2021.

As late as December 2021, the yield on US 10-year government bonds was under 1.5 per cent, a clear signal that the weight of investor money was pricing in many more years of low inflation and a tepid - at best - tightening of monetary policy from the US Federal Reserve.

It was a similar picture in Australia, with the 10-year yield hovering around 1.5 to 1.75 per cent with the 3-year bond tracking below 1 per cent on the expectation that economic growth and inflation would remain weak for an extended period and, as a result, the RBA would not be hiking much, if at all, in the years ahead.

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The market was wrong, and massively so, even though there were a myriad of indicators pointing to an unleashing of inflation pressures in the year ahead and even though inflation started to accelerate around the middle of 2021.

Less than a year after the market mispricing, the US Federal Reserve and the RBA have embarked on a rate-hiking cycle only a few forecasters could foresee. The yield on 10-year bonds is tracking around 4 per cent.

The bond market is on track to have its worst annual return ever, such are the losses for bond holders in this incredible bond market crash.

Are the markets wrong again?

The 4 per cent yield on bonds is predicated on inflation staying ‘high’ until well into 2023 and perhaps lingering above central bank targets until 2024.

The deceleration in inflation is thought to be slow and moderate in other words and will require a lot more monetary policy tightening.

Markets look to be wrong again, pricing in persistently high inflation and further aggressive interest rate hikes in the US and Australia.

Each minor pullback on bond yields in recent weeks has been quickly reversed and added to not so much by hard data, but by some increasingly absurd anti-inflation zealotry from the US Federal Reserve and some other short-sighted central bankers.

As noted previously, there is a long and growing list of indicators pointing to sharply lower inflation kicking in strongly within the next few months.

That list includes:

  • Lower commodity prices

  • Slower economic growth

  • Labour market indicators are turning after several years of unrelenting expansion

  • A free-fall in global freight shipping costs

  • Wealth destruction from the falls in stocks, bonds and property

  • Fiscal policy is about to be moved to a neutral, even slightly restrictive stance

  • Supply chain issues relating to semiconductors, timber and cars, plus a few others, are close to full resolution

And while there is some residual impact on inflation from dwelling rent and energy costs, these too are likely to reverse in the next couple of quarters.

Where to for markets?

It is always a tricky game to forecast where markets will be in a year and, to be frank, it doesn’t matter much what the actual yield on 10-year bonds, for example, is if the fundamentals lead to a material change in direction.

Whether the yield on a 10-year bond is 3.25 per cent or 2.5 per cent in a year is not really the point when noting that markets are wrongly priced today. It is just noting that at around 4 per cent, the yield on a 10-year bond is not taking account of the risks that inflation will fall sharply and that the monetary-policy zealotry now being seen in many quarters will be replaced, at some stage, with a capitulation that inflation did in fact decelerate at a rapid pace through 2023.

In the US, inflation has already eased. The last three monthly changes in the CPI have been zero per cent, zero per cent and 0.4 per cent. A repeat of these sorts of results would see inflation quickly track to 3 per cent by the middle of 2023 and 2 per cent thereafter.

If this were to play out, many would look back at today’s high bond yields and low stock prices and ask why it took so long for the market to realise inflation pressures started to ease around the third quarter of 2022.

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