Implications for Major Asset Classes
• The Fed has shifted to an average inflation target, rather than a simple 2% level.
• It signaled that it will tolerate higher inflation, which will likely result in more-negative real interest rates.
• This has important implications for all major asset classes, including bonds and stocks.
Today, I focus on the Fed’s change in its targeting of inflation, announced by Chairman Powell last month. The Fed will now target inflation that “averages 2% over time,” rather than a simple 2% target as previously. If inflation runs below 2% for a while, the Fed will then “aim to achieve inflation moderately above 2% for some time.”
To me and to many observers, this means that the Fed will allow higher inflation. Note that the Fed’s statement says that it would allow above-2% inflation after below-2%, but not the other way around. Next year’s inflation expectations have already jumped above 3% (see chart above) – the highest in six years – before backing down this month, to 2.7%. Core CPI inflation, while still low because it’s always depressed during recessions, already started to rebound, at 1.7% in August. This will likely lead to higher inflation and therefore to more-negative real (net of inflation) interest rates.
Implications for Bonds And Stocks
Higher future inflation will have important implications for fixed-income investors and other defensive strategies. Treasury bonds are not compensating investors even for current inflation of 1.7%. By investing in the 10-year Treasury, for example, investors commit to around a 1% loss in real terms (0.7%-1.7% rounded, see chart above). Inflation-indexed Treasuries (TIPS) are also providing a real yield of -1% (see chart above). That is, investors in both 10-year Treasury and TIPS would lose 1% of their purchasing power per year, with certainty.
Corporate bonds, with their slightly higher yields, are barely making up for inflation. If inflation rises, then all bond investors will lose in real terms. This loss will come over time (if bonds are held to maturity) or sooner on a market-value basis, if the Fed lets interest rates rise. Rising rates would be devastating given the enormous debt load – but that’s a separate discussion.
The recent rally has brought stocks to extremely overvalued levels. The S&P 500 is trading at 3.8 times its book value – its highest since Jan-2001 (which preceded the 2001-02 bear market) and well above its 2007 and 2019 levels. In its 150-year history, Shiller’s P/E ratio has been higher only in 2018 and during the dot-com bubble of 1998-2001:
A popular argument for higher stock valuation has been that interest rates are lower. So, a hint of rising inflation and interest rates might be the pin that pricks the stock bubble. Recall that as the Fed was normalizing interest rates in 2018, the 10-year yield crossing above 3% in October-2018 was what initially triggered the selloff. This time, the threshold is likely much lower because of larger debt and near-zero (or negative) global interest rates.
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