Market Extra: Consumers’ dashed hopes for end to pandemic at risk of spilling into higher inflation expectations

United States

U.S. consumers’ dashed hopes for an end to the pandemic are at risk of morphing more broadly into higher inflation expectations over the next year. And that’s the biggest risk facing financial markets through mid-2022, according to Jefferies LLC economist Thomas Simons.

“The longer the economy and society remain distorted or abnormal relative to what we expected pre-Covid, the longer and higher the inflation environment can persist,” he said via phone Friday.

Survey results released by the University of Michigan on Friday show consumers suffering a loss of confidence in early August that professional forecasters hadn’t expected — in what Jefferies describes as a rare, emotional knee-jerk reaction to COVID-19’s delta variant.

Behind the unease is the sense that masks, social distancing, remote work from home, endless booster shots and the constant fear of becoming sick is turning into the new norm. Meanwhile, household expectations of inflation over the next 5 to 10 years rose to 3% from 2.8% in July, economists said.

As investors and traders continue to debate how transitory recent high inflation readings will turn out to be, there’s a growing feeling of worry in some corners of the market. In a BofA Global Research note Friday, Ethan Harris says the Fed and investors “may be underestimating the underlying inflation pick-up,” by not paying enough attention to the right measures. And Jay Hatfield, CEO of Infrastructure Capital Advisors in New York, says the Fed has already “lost control on inflation”.

For now, ongoing support from the Federal Reserve is keeping markets relatively stable and “there’s lots of cash floating out there looking for places to go,” according to Simons, a money market economist.

After the release of the University of Michigan survey, long-end yields BX:TMUBMUSD10Y remained broadly lower and major stock indexes, SPX and DJIA, were aiming for another record. Meanwhile, as of yesterday, so-called breakeven rates measuring market-based expectations for inflation five to 10 years out continued to moderate since May.

Until Friday, long-end yields had been rising for much of August, a reflection of a market that’s adjusting to the likelihood that the central bank will taper its $ 120 billion in monthly bond purchases.

What a more dramatic, inflation-driven adjustment might look like is hard to say because much will depend on how the Fed chooses to respond and whether traders and investors begin to price in policy missteps, Simons said.

Meanwhile, the risk of inflation serving as the next catalyst for a dramatic adjustment in markets remains great. Not only is the central bank not able to ignore rising inflation expectations, according to Jefferies, it isn’t in a position to combat them with interest rate increases for possibly up to another year or more — given the need to taper its bond purchases first. And tapering on its own wouldn’t address the issue of rising inflation in the short term, Simons said.