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Bond market ‘somewhat chill’ about inflation effects, macro strategist says

Jurrien Timmer, Fidelity Investments Director of Global Macro, joins Yahoo Finance Live to discuss inflation expectations in the bond market, the Fed's dual mandate, and the likelihood of a recession.

Video Transcript

- As evidence seems to be mounting that inflation may finally start to ease, but will getting it under control trigger a recession? That's the big question here. And joining us with the answer to that question perhaps and more is Fidelity Investments Director of Global Macro, Jurrien Timmer. Jurrien great to have you here with us today. So has inflation peaked from your perspective.

JURRIEN TIMMER: Well, the hope is that it has. And if you look at, of course, the CPI report, which was a bit of a shocker when it came out a few weeks ago, it kind of put some cold water on the notion that the rate of change was speaking as it eventually should, right, I mean, in terms of the base effects and all that. So that had kind of moved the Fed further into restrictive territory or at least the market's perception of it. And we got to kind of a 4% terminal rate and talk about multiple 75 basis point moves in a row.


But behind the surface, we see in the TIPS market, that the inflation expectations are actually coming down at least via the TIPS market. And we can argue whether the TIPS market is an accurate reflection of where inflation is going. But the five year TIPS break even peaked at about 3 and 3/4% in March. It's about 2 and 3/4 now, so it's come down about 100 basis points.

And the five year five year forward, which is a fancy way of saying what investors expect five year inflation to be five years from now, that really hasn't budged. It's been around 2 and 1/4% for quite a while even during these periods of very much soaring inflation. So the bond market seems to be somewhat chill about long-term inflation effects. But again, we have to see who is right. But that's what the market is saying right now.

- Jay Powell doesn't seem to be too chill about it. He's commenting of course in that roundtable discussion today over in Portugal, and just want to play you one thing that he had to say, Jurrien.

- Since the pandemic, we've been living in a world where the economy is being driven by very different forces. And we know that. Well, we don't know is whether we'll be going back to something that looks more like or a little bit like what we had before. We suspect that it'll be kind of a blend. But in the meantime, we've got a series of supply shocks. We've had very high inflation now across the world certainly through all the advanced economies. And we're, to Augustine's point, we're learning to deal with it.

We have-- our job is to find price stability and maximum employment in the case of the Fed in this new economy with these new forces. And it is a very different exercise than the one that we've had for the last 25 years. Nonetheless, the goals are the same.

- Of course, he talked about the challenges of doing that and said that the pathways have gotten narrower to a so-called soft landing. So what can we expect from the Fed? Are they going to be forced to back off these interest rate increases.

JURRIEN TIMMER: It's a great question. And of course, the Fed has to thread the needle here. Up to this point, since really for a long time, for the last several decades, the Fed could always err on the side of maximum employment because inflation was MIA. So it could always sort of overfocus on one mandate while maybe putting the other mandate on the back burner. And that obviously is no longer the case. Inflation has been much more persistent than I think anyone thought, including the Fed.

And of course, if I were at the Fed, I would be concerned about temporary supply shocks or temporary or transitory inflation becoming more entrenched in terms of how people behave, you know, what their expectations are. And that's how you can get chronic inflation. And I think the real test going forward is if the economy were to weaken significantly, and it's weakened some. I mean, growth is slowing as you might expect during this late cycle phase of the economy. But the employment data are still very, very strong.

So I don't think a recession is imminent at all. The yield curve has been flattening but it isn't inverted yet. And I think the-- so I think the Fed has licensed to kind of keep pushing the Fed funds rate higher and more into restrictive territory, which be which would be above 3% or so. I think the real test going forward is as inflation does come down, at least on a rate of change basis as the base effects finally kick in, the question is what does it go down to? Does it go from eight to two?

I think that's probably unlikely. Or does it go from eight to only four? And if it gets to four, which is still twice what the Fed's target is, and the economy is then weakening and maybe employment growth turns negative, that I think is the moment where the Fed has a real dilemma. Because then it has to choose whether to accept higher than targeted inflation in order to save the economy. And I don't think we're there yet but we could get there at some point.

- Jurrien, you think the markets are cheap yet?

JURRIEN TIMMER: I think the markets are fairly valued. So I look at a very simple metric. I look at the two year Treasury yield as a proxy for where the Fed cycle goes. And that is a good input into equity valuation per the discounted cash flow model, right? So the DCF model puts in earnings growth in the top in the numerator an interest rate or cost of capital in the denominator. And so far, what we've had is earnings growth has been good, about 10%.

And we'll have to see what earnings season will bring in the next few weeks. That's kind of what everyone is waiting for to see whether those estimates of 10% growth this year will hold. But in the denominator side of that equation, the cost of capital of course, has been going up as it has been for everyone whether you're a mortgage or a home buyer or a corporate borrower or what have you.

And as a two year yield goes up, the cost of capital goes up. And that's been a good proxy. So the forward PE on the S&P 500 peaked at about 23, 24. Today, it's around 17, fair values around 16. So all the market has done so far is to catch up to a lower fair value per because interest rates are rising. But it hasn't overshot it. Like it's not like the market's trading at 12 times expected earnings when it should be at 15. It's just at 16 when it should be at 15 or at 16.

So the market has-- is at fair value. It has been. But it's not quite enough, especially where we're all waiting for kind of the other shoe to drop on the earnings front. And maybe it won't drop. Maybe the earnings side will pull through. But that is kind of the balancing act here.