The combination of high U.S. inflation and Russia’s invasion of Ukraine has discombobulated U.S. markets. From Friday to Monday, traders effectively reduced the number of expected rate increases by the Federal Reserve to six from seven by next February, even though, by most accounts, the inflation outlook has only worsened.
What gives?
The Fed has no good options, and the market is reflecting the indecision that central bankers surely must feel. Europe’s biggest ground conflict since World War II has sent energy prices soaring and shaken financial assets, stirring fears of stagflation that the U.S. hasn’t experienced since the 1970s. There are no great policy remedies for stagflation in normal times, and central bankers have few tools at their disposal with interest rates already near zero. Predicting what they’ll do is a job for mind readers, not traders.
The market isn’t blind to the price pressures across the economy. Breakeven rates on five-year Treasury notes, a measure of market expectations for inflation in the period, are actually increasing and drawing near the highest level in decades. One interpretation is that the market thinks the central bank will simply have to accept inflation running above its long-run target of 2%. Nothing about that scenario is positive, but the Fed may come to see it as the better of two bad choices. The alternative — crushing growth to try to rein in prices, and probably bringing down the stock market in the process — just isn’t palatable.
Another reading of the market is that energy-fueled inflation simply isn’t worth fighting — at least not by the Fed. According to Bloomberg Intelligence strategist Mike McGlone, Brent crude oil prices around $100 a barrel aren’t likely to persist for long and could be set for a big downturn.
The cure for high energy prices is increased production — including potentially from U.S. shale producers sitting on the sidelines — but the levers of monetary policy at the Fed’s disposal aren’t likely to make a significant difference. And according to McGlone, even if production doesn’t ramp up to bring down prices, the Russian invasion of Ukraine may ultimately just accelerate the move away from oil and gas toward electric cars. Recessions are also great at cooling oil demand.
In the near term, none of this spells good news for the U.S. economy, but it does support the market’s view that the Russian invasion hasn’t made higher interest rates any more likely and may in fact have done the opposite. Some of this is reflected in the disjointed moves in daily bond yields recently. Two-year Treasury yields plummeted 12 basis points on Monday, or 0.12 percentage point, the biggest one-day drop of the year. The 10-year yield fell nine basis points. It’s unclear how much of that truly reflects rate expectations and how much is just the famous investor flight to perceived safety, and the push and pull has been intense.
There’s one obvious problem with looking for monetary policy cues in financial markets: They’re often wrong. As my Bloomberg Opinion colleague Bill Dudley underscored Monday, there’s a chance that the market is grossly underestimating the potential for rate increases.
But the markets are getting one part of this narrative right: All of this is extremely complicated, and the likelihood of a policy misstep looks extremely high. Until the path ahead grows clearer, expect a lot of mixed messaging from the markets. These times are confusing, and traders don’t have a crystal ball.
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