Franklin Templeton’s Fixed Income Chief Investment Officer Sonal Desai says January inflation print confirms that the “last mile” of disinflation may prove to be a lot harder than markets expect, and investors should brace for more volatility and a possible move of 10-year Treasury yields back in the 4.25%-4.50% range.
Desai notes: “January’s US inflation print came as an unwelcome spoiler for financial markets, dealing what looks like the final blow to hopes of a March interest-rate cut, sending bond yields back up and triggering a major one-day correction in equities.
“Looking forward, however, I think we would do well to keep in mind three points:
- The US economy is obviously in rude health. We’ve seen strong numbers on the labor market, continued robust increases in wages, and upside surprises on consumer confidence, retail spending and gross domestic product growth. Against this background, it’s hardly surprising that disinflation has stalled. Yes, there was a transitory component due to supply disruptions which are now being resolved. But as I argued from the very beginning, higher inflation pressures partly reflected strong aggerate demand—and that keeps going. Supply has recovered, including with the productivity rebound, but not enough to offset continued strong demand.
- Supply shocks are not completely out of the picture. Disruptions in the Red Sea have already caused a rise in transportation costs that eventually might be passed on to consumers, and tensions in the Middle East show no sign of abating. And whether you look at China or Russia, geopolitical risks overall appear on the rise.
- Fiscal policy remains very loose, with very little chance of retrenchment now that we have entered an election year.
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“When you combine these three considerations with the signals in the latest inflation prints, the risk that inflation will prove stubborn appears significant—and by the way, measures of sticky inflation that the Cleveland Fed and the Atlanta Fed track send a very similar message. It does not mean a risk of inflation rising anew, forcing the Fed to consider additional hikes. But I think it does imply higher uncertainty on how long it will take before inflation is sustainably back to 2%.
“The Fed has been wise to dampen market enthusiasm in the past few weeks, after having abetted the irrational exuberance of end-2023. To me, the second half of the year remains the most likely time for a first interest-rate cut, and chances that the fed funds rate might fall by more than 75 basis points (bps) this year appear slim. If anything, we might only see a reduction of 50 bps.
“This is not the first time that markets’ fervent hopes of early and large rate cuts have been dashed—and it won’t be the last. Financial markets want to anticipate a significant monetary easing, and I think that when we get the next datapoint, or a Fed official making the next dovish statement, we’ll likely see rate-cut expectations surge again. To be dashed yet again, I would wager. So, brace for continued volatility, and I reiterate my call for 10-year Treasury yields in the 4.25%-4.50% range.
“Finally, the long run: Activity data and inflation numbers all suggest that monetary policy is not too tight at all. In turn, this means that the neutral rate of interest is higher than what the Fed has penciled in and markets keep expecting. Some Fed officials have recently signaled as much, and I have made this point for quite some time, but it bears repeating—the neutral real rate is likely closer to 2% than to the Fed’s 0.5% estimate, and this implies that the neutral fed funds rate is likely closer to 4%. Investors should bear this in mind as they plan their investment strategy for the easing cycle,” says Desai.
