2021 was a historic year for markets and the broader economy. For the first time, seemingly in ages, there was a serious shift in realized inflation and the broader inflation outlook. This has ramifications, potentially, for risk assets, bonds, and, of course, the Fed. To help break things down and understand what comes next we speak with Jon Turek, author of the Cheap Convexity Blog and founder of JST Advisors. Transcripts have been lightly edited.
Joe Weisenthal:
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway:
And I'm Tracy Alloway.
Joe:
Tracy, It's been a long time since we've done a sort of — I don't know if it's been too long, it's been, it feels like it's been a while — since we've done a pure sort of macro episode. We obviously do a lot of micro and that's been one of the fun things about 2021, but I think it's time to switch back to the macro.
Tracy:
I was gonna say we've been distracted by the micro in attempting to put together a better picture of the macro, in all fairness. But yes, you are right. It's been a while since we talked about the general outlook for the economy and for markets, and of course we are looking ahead to 2022 and there are a lot of things going on. And a lot of things that people are concerned about. So obviously we have inflation worries and then we have a slowdown in China as well. And then we have, of course, the Fed's reaction function, and there are still a lot of questions over what exactly it's going to prioritize going into next year.
Joe:
Yeah, exactly right. And you know, I think the other thing about this environment and this kind of applies, it's like nobody has any familiarity with this type of economic environment. I mean, it's pretty new. So yes, we've seen periods of elevated inflation before, for sure. But by and large, this is not like the 1960s or the 1970s. It's different conditions. Employment is growing extremely fast. We had a pandemic, we're still in a pandemic. And so that is totally new. The policy responses that we've seen are new. So I think kind of what makes this interesting is just, yeah, everyone can reach for analogies, but there are no real experts who could say, you know, this is the playbook or anything. Everyone is on some level dealing in uncharted territory.
Tracy:
Yeah. It's a very unusual business cycle. And we've talked about this before, but we basically squeezed in an accelerated business cycle right after the pandemic. We had a very short, sharp recession and then the recovery started almost immediately largely thanks to the stimulus efforts from various governments. But of course the question is, what does the cycle look like? Does it behave like other cycles? I've already seen lots of people talking about how we're late cycle, all the signs point to a late cycle. And it's like, well, it's been, what, two years since this started, like, that would be a pretty fast cycle?
Joe:
Yeah. And then I guess the other medium-ish to long-term question is, does something change meaningfully? And I'm thinking about, say, in inflation and, you know, obviously prior to this, we had, you know, great moderation or disinflation or the Fed could never hit 2%. Now we have, you know, over 6% inflation, but does this mean revert? Does it just go back to the old way or do we enter into some sort of new regime where inflation is persistently above [trend] and there's much more inflation volatility, sort of, these are all kinda difficult questions to know right now, but the big ones that people will be asking over the next year and beyond.
Tracy:
Yes, indeed.
Joe:
So I'm very excited to have as our guest today, the perfect guest for a macro conversation, he's been on Odd Lots before, at least a couple of times. And in terms of sort of macro thinkers, I think one of the clear and most useful guests that we speak to. Pleased to welcome back on the show, Jon Turek. He's the author of the Cheap Convexity blog and the founder of JST Advisors. I think this is maybe his third time on the show, but someone who I always get a lot of insight reading his stuff and having him on the show. Jon, thank you for coming back on Odd Lots.
Jon:
Hey guys, thank you so much for having me.
Joe:
We're gonna talk about 2022, but what for you was the sort of big surprise of 2021? Like what was your, what was your lesson? What was your takeaway from what we saw this year?
Jon:
You know, I think that one of the things that really kind of changed and this is pretty obvious, you know, ex-post, is kind of the stickiness we've seen in inflation this year. Going back to before the year, there was kind of this obvious forward-looking effect that inflation would be higher given the supply bottlenecks and also given the base effects from 2020 and the pandemic, negative oil prices, etc.. But kind of seeing the stickiness and broadening out of inflation one, we really haven't seen that in almost 20 years. I mean, there's this famous joke for the U.S. that really the only thing that goes up in price is education and healthcare. And that's not been the case this year. And I think, especially as this relates to Fed policy, is we kind of entered this year with this thinking of, okay, was the Fed reaction function, especially had it changed post Jackson Hole 2020, and they introduced this idea of Flexible Average Inflation Targeting (FAIT).
Would that be the best position to look through and for the Fed to basically avoid a 2011 ECB moment where they were, you know, kind of hawkishly reacting to spot inflation that was not telling a demand story. But now I think what's becoming clear is that while there are supply bottlenecks and there are kind of supply fragility that have weighed on spot inflation, there's clear that there's also excess to demand and that the Fed has kind of had to, you know, have this broader shift that's really started since June FOMC, but has kind of really been enhanced post-Powell reappointment that, you know, FAIT may still be the policy playbook, but it kind of has to adjust to the force that fiscal policy was at the lower bound and, you know, kind of change the nature of where nominal GDP is now and probably for the next, you know, 12 months.
Tracy:
So how much of a role do you think demand actually played in the price pressures that we're seeing now? And I realize it's sort of tough to disaggregate supply versus demand in all of this, but maybe give us a little bit more color on, on how you're thinking of it?
Jon:
Yeah. You know, I think that looking at especially retail sales on things like two year-stacks and seeing how above trend nominal consumption is, I think it's, I think it's amplified the supply fragilities, so it's kind of created a perfect storm for prices. And, you know, I don't think that it's only a demand issue, but it's clear that we had a recession where household income in aggregate went up, which is obviously most peculiar. The thing that's worth thinking about going into next year, especially as inflation will peak in Q1, it will come down in Q2. The question is what is the run rate? You know, what is the handoff that the economy's dealing with? Well looking back at 2020 and beginning of 2021, you can argue that transfer payments and things of that nature made a big difference in wage replacement, or even for some, you know, income quartiles, you know, wage-enhancement effectively.
But you know, now looking into the economy into 2022, especially at the lower end of the income distribution, wage growth is pretty robust. So, you know, there is kind of this, there's not this just big drop off because we're a year out from when there was a lot of retail sales. You know, wage growth is broadening out in the economy and is really strong as we kind of have this reset of wages through the Amazon-Walmart effect at the lower end, that it's hard to have this, you know, big deceleration in demand that will broaden out or help inflation come back to the Fed’s 2% target in an environment where wage growth is really strong. And I think that's also kind of the point missed about this year, right? Is there are these supply-side fragilities, especially things that were enhanced in Southeast Asia through delta when we had Malaysia shutdowns and that affected semiconductor fabs and etc., but, you know, income growth, especially on the wage side, across the Western world has been really strong this year. And there's no real sign that this labor tightness is going to give away. We may get more labor supply and participation rates may go higher, but labor's pretty tight right now. So wage growth should continue. And I think that kind of, you know, makes that handoff in terms of like things coming back from mean reverting to normal next year, kinda tricky.
Joe:
I think this is a really interesting point. I'm glad you brought this up, this idea, it's like, okay, sure. The transfer payments are gonna come down. There's gonna be at least some relative fiscal tightening or the fiscal impulse won't be what it was. But there is also this thing, you know, called like endogenous demand growth where not everything is just about transfers and in an environment in which there's a lot of momentum, particularly at the low end, that has to be a plus.
One question though, on this idea of demand, because in addition to a high level of income growth and a high level of aggregate demand, we've also seen this shift that a lot of people are talking about, including many of our past guests, of goods consumption versus services consumption. That hasn't normalized. Some have said that -- more than the actual demand itself -- is what's contributing to sort of persistent bottlenecks or maybe persistent inflation. If that normalizes, if like, okay, we get, you know, it seems like, you know, I don't know what's gonna happen with the virus, but if that normalizes, can we get some further downward pressure on inflation even with demand remaining quite robust?
Jon:
Yeah. You know, I think you probably will. And I think that the broader point that I wanna make is that, you know, inflation will come down. The question now is what is the run rate? And getting that run rate back to 2%, you know, is seemingly getting a little harder especially for next year. And I think within this good-services composition, there is goods pressure that is going to come down as you know, the economy does handoff back to more service-oriented as especially the U.S. economy has always been. But there's also this element that goods are not going to go back to where they were in the 2010s where you saw many years of goods prices actually printing deflation and goods prices were falling year to year. And, you know, given this level of nominal demand being a little more sticky, I think it's hard to kind of see that even as, you know, we get into next year and it's like, well, everyone bought a washing machine or everybody bought a car.
I think that argument does hold weight. The question is does it get you all the way down? And does it get you all the way down in some senses to start printing negative prints on durable goods? And that I think is just, it's just a harder bet to have given the level of demand that we're continuing to see. And I think that's kind of like, the broader macro point of this to me is, you know, and I think this is especially relevant with the 10-year at 140 (basis points) and the market very skeptical of forward-looking growth is we're in the midst of this public sector to private sector handoff and everyone kind of doubting it. So, you know, I think that that story is actually more alive than the market is giving credit for.
Joe:
Just real quickly though. Does it need to come all the way down? Like, what are the stakes of getting back down to 2% versus maybe still being over the Fed's target?
Jon:
Yeah. Yeah. So, you know, I think the question for me next year on inflation run rate is, is it below three or much above three? Because I think that, you know, if we start getting to, you know, if you do like simple math and you start going through, okay, what is Q2 inflation gonna start looking like? And lets say we assume that month over month prints go back to 0.1s and 0.2s – and 0.2s are actually pretty high relative to the last 10 years. We've become kind of immune to that as we've seen 0.7s and 0.9s. But if you start getting 0.2 month over month prints, you're still gonna get back to an inflation number around 2.5% by the end of the summer next year. And I think that number -- while it's still high relative to the Fed's target and in terms of their moderate overshoot, I think that would be a nudge high.
I do think that that gives the Fed enough room to say that listen, inflation is high, we’re hiking, but there's marginal risk of us hiking too much that we're going to crush this thing, which I think really is the risk now, right? The risk now is that inflation comes down in Q2, but it comes down to 4%. It comes down to 3.5% to 4%. And in that world, does the Fed say that is not tolerable to us? That could meaningfully affect inflation expectations. And we have to act more aggressively than we have in the last few cycles. And I think that's kind of what the market is weighing now, right? There's this residual risk premium that the Fed is gonna have to almost hit the kibosh or kind of smash this thing because, you know, spot inflation is gonna start leading to a de-anchoring of inflation at expectations or at a level that they don't see as tolerable. So I think that's really the big question of next year. And we'll probably find out, you know, late Q2, which is why for me the June FOMC is the one that is circled.
Tracy:
So I wanted to go back to what you said about the 10-year yield. So currently sitting at 1.45% or thereabout, and one of the big histories of this entire year has been why bond yields are so low, even in the face of the Fed ostensibly beginning to taper its balance sheet and maybe getting more worried about inflation. And I've seen all sorts of explanations for it. One of our guests, Joseph Wang was talking about the idea that banks are just buying lots more Treasuries than they used to. And that kind of puts a floor, or maybe I should say a ceiling on yields, because you always have that huge chunk of demand there waiting in the wings. And I've also seen other people talk about it -- it's sort of what you were saying. This idea of investors, not really buying the public-to-private handoff, thinking that the Fed is inducing some sort of policy error and it's going to have to backtrack at some point. So how are you thinking about the bond market at the moment and what the 10-year is actually telling us?
Jon:
Yeah, you know, I think it's especially one of the more prevalent questions right now, as we're gonna end the year probably with, you know, with between 11% and 12% nominal GDP growth and you know, all the 10-year does is rally and we're entering a Fed hiking cycle and it still rallies. And I actually think it does make more sense than it would appear on the face. You know, I think looking at things like five-year, five-year OIS, which the Fed and, you know, market participants kind of look at as an estimate of, you know, where the Fed will get to in terms of the hike cycle or destination, which equates to around the 10-year U.S. Treasury yield, I think there is this element and we were just talking about this, of this residual risk premium that inflation got too high and the Fed is going to have to react asymmetrically to it next year.
And that is why I think we've kind of had not only this front loading of the hiking cycle, but also this relentless flattening as the market has had to weigh the probability that if the Fed has to go, let's say faster than quarterly next year, or has to go at a pace that's more than 25 basis points a meeting, then the chances of the Fed overdoing it go up. And we also know that we're still in a very low r* world. So if the chance is that the Fed overdoes it, the chance is that the forward-looking bond market is like, okay, that raises the odds that we're actually gonna end up back at zero. So you're in this interesting paradox where the bond market is weighing hikes, but also weighing what kind of hikes we get. And the fatter that residual risk premium is -- that the hikes we get are disruptive or too much given the level of spot inflation or the worry about inflation expectations -- that actually paradoxically raises the chances that the Fed will be back at zero because we're in this low r* world and the assumption is that if the Fed over does it, that means the next move is to cut.
And if they cut that they go to zero. I think that's kind of the calculation that the bond market is making right now. And which is why I think, you know, we're in this interesting time where people like me have this, you know, pretty positive view about nominal GDP growth next year. And then we look at the 10-year, it’s like, well that's not confirming it. And I think the reason that's not the trade yet is the market kind of has to get through this period of what is the peak of inflation and what is the inflation run rate? And those are both questions we don't have the answer to yet. And I think until we do the market's not going to feel comfortable taking these ‘destination trades’ higher.
Joe:
Is the possibility of a highly aggressive hiking cycle, something which we haven't seen in a long time, is that showing up in risky assets anywhere? Is it showing up at the stock market?
Jon:
You know, I think that we have had a little bit of multiple compression this year. I mean, especially looking at, you know, what Ford earnings are projected to do. I think there has been some, but you know, a question I get a lot is, well, the bond market is flattening a lot, so shouldn't stocks care? And you can make an argument that 5s30s may actually be inverted this time next year and while that's always, or at least in 2s10s, that's always traditionally a harbinger of recession. And, you know, I think that actually that there should be this delink between kind of the slope of the yield curve and kind of equity market risk premium. When I think that, you know, from a distribution perspective, the bond market has to weigh the risk, especially in things like 5-year or 10-year U.S. Treasury yields. The bond market has to weigh the risk of kind of the whole trajectory of Fed policy where it's like, okay, well what's the percent chance they go too much? What's the percent chance that in three or four years, they have to take it back?
And thinking about that kind of whole scope vis-a-vis the equity market, which is like, well, next year earnings growth is still gonna be really good even if the Fed goes four times. 2023 earnings, they may have to come down a little. And I think that's what we've seen in forward PEs coming down actually, or at least not really moving all year even though earnings growth and earnings estimates, they need to be picked up, is I think there is that element. But the equity market's not gonna be like, oh, in four or five years, the Fed may have to go back to zero. You know, I think in terms of time horizons, they're really operating on different ones. And the bond market is, you know, leaning into its symmetry and the equity market is leaning into its own. And I don't think necessarily, you know, they have to be saying the same thing. In fact, I think it would be odd if they were.
Tracy:
Just on the idea of whether or not a rate-hiking cycle would be bad for risk assets or what impact it would have, can you talk a little bit about emerging markets? Because, of course, if the Fed is raising rates then theoretically the dollar should go up. That's bad for people that have a lot of dollar-denominated debt or, you know, historically it has been bad for many developing economies. So how do you see that unfolding? And I’ve got to say the dollar index already has been pretty strong going into the end of this year.
Jon:
Yeah. You know, I think it's a really interesting one. And I think that for EM, the question for the Fed next year is not if they're hiking, but what they're hiking at relative to market pricing. And I think, you know, EM has had this tricky few months and you could really argue since the summer, partly because we've had to continuously add hikes, especially into the 2022 implieds. And those added hikes have come with the asymmetry that the next pricing is towards a hike and not towards less. Right? For instance, June FOMC market pricing for next year, went from zero to one with the asymmetry of it being two. It went from two to three with almost the asymmetry of it being four. And I think that's kind of what the dollar has leaned into, right?
The dollar has leaned into, okay, they're hiking and it's more likely that they hike more than less. And now I think we're entering this kind of interesting period that I think is especially relevant for emerging markets where I'm not convinced the next hike is actually dollar positive where the rate change from zero to one, one to two, two to three, have all been dollar positive. And we've seen this pretty significant and dollar rally especially since Q3. But I think what's interesting now is if you get to, if the market goes from three to four, there are few interesting externalities. One, I think that lessens the odds that the Fed is operating by themselves. And this, I think especially matters for emerging markets because it kind of goes through the dollar channel, is if the fourth hike in the market priced for the Fed happens, I think that raises the chances that the ECB, the RBA, the Riksbank, central banks that have been, you know, kind of more into this, not necessarily transitory message, but next year is too soon even if they've given up on transitory.
I think that hike makes it much more likely that central banks like the ECB go “hold on a second, maybe 2022 should be live in terms of rate hikes.” The other thing that I think is really interesting is if we went to four, that means to go at a quarterly pace, the Fed would have to go in March, but also that they would be hiking in the same meeting that they're basically ending QE. And now there's no necessary precondition to the Fed having to have a gap between the end of QE and rate hikes. We only know that the Fed can't hike while they're buying bonds, but I think in terms of a message or signal of intent, that would be a pretty big one where the Fed would say there's no gap in between the end of QE and rate hikes.
And that would also, I think, make it much more likely that central banks like the ECB, like the RBA, kind of have their moment of, yeah, we're also live this year. And then that kind of speaks to something that I think is very different this cycle than last, which is in this period of 2018 was very Fed-dominant, very U.S. growth dominant, but kind of looking into next year, you could be in this much more coordinated policy growth dynamic, which I don't think will have the same dollar spillover. Now, if we went to four next year, then the chances of five, I think actually become maybe the same, or even less than the chances of three. Because five would be the Fed saying, okay, we're off. We're not on a quarterly pace. Something really bad happened and we have to have to address it right away.
So I think in terms of the dollar, I don't know that it's obvious sell, but I do think there are elements that are actually, you know, topping. And I think from an EM perspective, you know, going into next year, I think the setup is fairly binary as it usually is with EM, where, you know, you could have a Fed that's kind of priced for what it's going to do, right? It's for the first time, we're not kind of incrementally adding hikes into the implieds for next year, at the same time, that terms of trade and EM are off the charts. On the other hand, you could have an EM where the Fed says, “Oh, by the way, we really have to stop this thing because inflation is too high,” and that's at the same time that you have political development such as Brazilian elections in October, etc., and you have a further mess. But I do think EM is going into next year, actually with some better buffers than people I think give it credit for, given that because U.S. demand is so strong, because the Chinese currency has been so strong this year. Terms of trade are really strong and current accounts have kind of stayed sticky to the surplus side.
I mean, we've had this year, you've had South Africa have a current account surplus, which is kind of unheard of, and it's not to say that that will last. It won't, but the question is, you know, same thing with U.S. inflation is kind of what does it come back to. For EM, the interesting thing for next year is, you know, all these guys have pretty much have hiked a lot. Terms of trade are really strong. If the Fed is not, doesn't have to say, oh, you know, inflation got too high, we have to do something drastic. Then this setup is actually pretty strong, especially, you know, as Chinese growth starts to, you know, bottom around here.
Joe:
That was a very interesting and useful framework. Can you just say a little bit more about China? I mean, Tracy's been obviously covering it a lot, the slowdown in China, and yet we have seen the Chinese yuan -- even during a period of dollar strength – I think the yuan has been even stronger. What is the dynamic there? You expect a reacceleration, what explains that yuan strength and how are you thinking about China and its contribution to growth and demand in in 2022?
Jon:
Yeah. You know, I think China has been probably, outside of the Fed and inflation, I think one of the more interesting drivers this year where, you know, we've clearly had this policy goal or crackdown on both the tech and property sectors that have, you know, obviously made Chinese assets underperform. But at the same time, we've had this massive outperformance of the Chinese currency. And also this outperformance that happened in the context of Chinese growth, you know, kind of decelerating faster than it has pretty much anywhere in the west. And I think, you know, something that I've definitely talked about with Tracy is China's had this interesting policy posture this year, where they came into this year with two things, one, they wanted to get the credit impulse lower because they thought, okay, you know, we did a lot in 2020, we got demand back, the global economy is strong.
They have politically become more sensitive to new credit in the economy, especially as it relates to the property sector, etc. So I think that there's been this impetus to bring credit lower, and then that traditionally weighs on domestic growth, which it did this time. I think the difference that happened this time and why China wasn't this, you know, kind of disaster for the global economy -- as it really did have a pretty big deceleration in its credit impulse -- is that China was able to not fully, but replace a lot of domestic demand that they usually got through marginal credit increase via the current account. And this is something that didn't happen the last two times that China has had these pretty stark credit decelerations where we saw post-2011, which ended up in, you know, kind of a commodity bust in 2014.
And we didn't see, you know, maybe 2018, which followed China stimulus in 2016, is China because of how strong U.S. and European demand was -- especially U.S. -- China was running a current account surplus of 3% this year. And this is in contrast to it basically drawing its current account to zero in 2018. And I think that China basically made the calculation that they could import the demand that they were offsetting by being tight on credit. It seemingly was a bet that worked. I mean, it's hard to say that, you know, China's had this robust growth period. It didn't, especially in a relative sense. But China was not this, you know, massive drag on global growth this year, even though it had a much weaker credit impulse, I think partly because it was able to import that lost demand. And I think that's what kind of, you know, they kind of set this up as China wanted two things from this year.
One is they wanted to offset some of the inflationary pressures that the rest of the world was feeling. One way to do that is to have a stronger currency. And then the other thing is that they wanted to have this tightening either on the credit side and I won't really speak to the tech side as I'm not an expert on it, is they wanted to really tighten credit post-2020 and the big credit acceleration they had then, especially as the property sector is extremely vulnerable right now, they wanted to replace that demand through the West, which is not too dissimilar to what the West effectively did post-GFC, right?
Post-GFC, the West basically let -- not purposefully and probably not as purposefully as China did this time -- the West went into austerity and China stimulated and kind of the way out was that, you know, Chinese demand carried the way. And this time, China made the, I think calculation, that they were going to let the West lead. They were gonna import that excess demand and that would let them, you know, achieve some policy tightening that they wanted to do anyway, without a big marginal cost to growth.
Tracy:
This leads very well into the next question I wanted to ask you, which is about the policy response going into 2022, because I think there is, I mean, there is this history that when things go awry in the global economy, China will start easing and effectively save everyone. And that might not be the case this time around given what you just laid out. But on the other hand, we are seeing China start to push back a little bit against the yuan and also show some signs of easing. So it just cut the reserve requirement ratio. Let's talk a little bit about rolling back some of the property curbs. How should we be thinking about that policy response going into 2022?
Jon:
I think this is really one of the more important questions. I think I kind of come at it with a China's not going to go full easing, i.e. there’s not going to be, well, there's a national party congress so we go pedal to the metal. You know, I don't really think that will be China's policy posture. I think what we are seeing though is -- and this became extremely evident when we had three separate macroeconomic stabilizer events in China -- that I think China is putting a floor in, in terms of where they’re going to let growth go. And I think this became really noteworthy over the past two weeks when three things happened, one, as you noted China basically said, “Okay, yuan has gone up a lot and we're comfortable with a strong yuan policy, especially as we're in this broader context of dual circulation and wanting to increase domestic demand, but it's gotten too strong.” And they hiked forex reserve ratio from 7% to 9%.
Then we also saw from the State Council and the politburo that there is more of a fiscal backstop that will probably kick in next year. And then on the monetary side, we saw that they're going to cut the triple-R rate again and have, you know, at least in the market been a little more aggressive on the liquidity side. So I think we've had these three, in theory, independent macro stabilizers that have all kind of happened at once, that I kind of think, give you the message that, listen, China's not going to go into next year and start doing massive fiscal or massive infrastructure or massive monetary stimulus through rate cuts. You know, I wouldn't even be surprised if the loan prime rate, you know, kind of China's now default policy rate, doesn't actually move down at all. But I think China is going through the process of, of narrowing the confidence interval of their growth range.
And I think we've reached the point now where growth has gotten too low, that they want it to pretty much pick up. And I think what you will see in the next two quarters is the credit impulse will pick up and China wants that, but they don't want it, you know, necessarily going bananas. So I think that's kind of what's different this time, is that China's not going to be this big marginal impulse to global growth. But I think China, especially as we've seen over the last two quarters, the fear of China being this big drag on global growth, I think will recede going into the first half of next year.
Joe:
I want to bring it back a little bit to the United States. And you know, thinking about this possibility of multiple hikes and maybe four, and, you know, maybe at some point if things were to go get a little too wild, maybe five. And obviously that doesn’t seem like that's anyone's base case, but I'm thinking about, you know, of course at the end, near the end of 2020, and the Fed unveiled its new framework, Flexible Average Inflation Targeting. And in addition to this sort of new framework change, we heard Chair Powell talk about things like inclusive growth and a true commitment to sort of maximum employment in a way that seemed different. Do you think, you know, if you think about how the market and investors are anticipating Fed action next year and beyond, would you say that it's a reflection of essentially the Fed having met its goals and the Fed having delivered on its commitment? Or is there a belief that actually in the end it'll be the same old Fed and that for all of the talk of a new framework and perhaps a slightly greater weight on the employment side of the mandate, that in the end, the Fed is gonna sort of be the Fed it's always been
Jon:
It’s a good question. And I think, you know, on the surface, I think a lot of people would say that it's, you know, kind of same old Fed. But I don't think so and the reason I don't think so is, you know, I think that part of what's made this recalibration in Fed pricing very uncomfortable is we were thinking about in the, you know, first half of 2021 that the first Fed rate hike was gonna come in 2024. And we've basically gone from no hikes until 2024 to three hikes in 2022 in a very short period of time. And I think that that has kind of come with the broader perception that this is a Fed that flinches, that FAIT is kind of dead. And, you know, I think going into next year, there is a possibility that FAIT does die, but it's a possibility that FAIT dies within kind of what the Fed told you in their monetary policy statement, which is that the goal of FAIT is to be reactive, right? It's not to be preemptive.
However, there was one thing that the Fed said they would be preemptive on, even within the context of fate. And that was inflation expectations. And inflation expectations, as we've known this year, is kind of this messy concept. But I think what's easier to say – and you could read the Jeremy Rudd paper and, and different papers have come out on this year that kind of know how messy it is to manage -- and we know that Clarida looks at things like CIE, the Fed’s common inflation expectations indicator — is that the Fed could decide that spot inflation so above target for so long has a risk of de-anchoring that it could require a faster pace. And that would actually be with their monetary policy strategy. And I think, you know, going into next year, more of a base case world, right? Where the Fed kind of hikes three times, it ends QE in March.
If you assume the first hike is going to be in June, well, what's gonna be the case in June? You're probably gonna have a sub 4% unemployment rate. You're gonna have prime age that's probably going to be back at pre-Covid levels. And I think there is this implicit bias from the Fed, and it may not come across in a higher u* star or a higher natural rate of unemployment, is that the natural rate of unemployment probably did rise post-Covid. And it may have not risen drastically, but I think the Fed is going to be less comfortable with the idea that you can get back to 3.5% percent unemployment and then have no marginal inflationary cost, especially at this point in time when inflation is in the sixes. So, you know, I think going into next year, there is this idea that it's like, kind of all over, same old Fed, whatever the data comes is [iaudible]
And I do agree that the Fed is now less preemptive in terms of policy being the dominant variable, not the data. The data now is definitely the dominant variable, and that was kind of the Fed shift post-June. But I think, you know, looking into June and you look at the FAIT checklist, you know something that Clarida gave a speech on in August that really caught people by surprise is well he said, I'm looking at the FAIT checklist and I could see it being hit by the end of 2022. And I think it's reasonable to say since, you know, the labor market progress we've had since August and the continued price pressure we've had, that that has just been moved forward six months. And I think it's pretty consistent to say that FAIT will actually be hit in June of next year and the Fed won't be, you know, kind of same old Fed-ing it in terms of, okay, how do we come up with reasons to hike when we’re really only scared about inflation? I do think inflation is the dominant variable in kind of this recalibration of policy, but I think this recalibration of policy also happened in the context of a labor market that is healing much faster than it has in past cycles.
Joe:
So before we go, Jon, you know, I wanted to get your take, obviously just sort of risky assets. And we talked about them a little bit before, about whether there's any evidence of them pricing in an aggressive hiking cycle, like maybe the bond market is. But by and large, it's been an incredible year. I mean, I think there's sort of two things that stand out for me. It's like one is, you know, at least in the U.S., but also I think elsewhere, headline stock indices have just done insanely, S&P up something like 25%, just like an incredible year.
On the other hand, we have seen this pretty intense sell off in what was really hot earlier in the year. A lot of the growthy stuff, tech stuff, meme stuff, etc. I'm just sort of curious, you know, how you're thinking about this. I don't know if you have a call on sort of like the S&P or think about that, but within the macro context, how does all of this play into the part of the market that most people observe most directly, which is the stock market?
Jon:
Yeah. You know, I think it's interesting going into next year. I think that there's kind of this broader narrative that we've been alluding to that, you know, the economy's not really going to be able to deal with this public to private sector handoff, the Fed is going to be a big, you know, impediment to the market. And something I do think is true is that, you know, the ‘Fed put’ has been re-struck lower. You know, and in terms of like distributions of where multiples can go given that, I do think it is significant. But, you know, I think more broadly is I think the market is actually readjusting now to the possibility that the Fed may have to be more drastic next year than especially originally it intended to, but also in terms of like, you know, the last 10 to 20 years of what it has done.
And I think that's become like really obvious in things like, you know, the really techy stuff and ARK and those type of things where, you know, they just cannot handle a hawkish Fed. But I think in terms of the market at large, and in terms of the S&P I think we're getting actually closer to an equilibrium point. And I think a lot of people think, I mean, I think going into next year, we're getting to the point now where a lot more hikes next year versus, you know, too fewer hikes next year, it's actually getting pretty close in the odds. I mean, I think given where spot inflation is there is this bias to kind of assume that, you know, the asymmetry is into more and the asymmetry was into more hikes for a long time.
But I think the interesting thing now is we're getting close to a pretty nice equilibrium point where, you know, inflation may be 4% but it also may be 2.5% And I think like the odds are kind of close. And I really think you should be on the side of 2.5% given what base effects will do starting Q2 of next year. And you get into that 2.5% world. That's still a world where the Fed is hiking because inflation is above target. And in terms of the FAIT checklist, it's all hit, but it's not a world where the Fed is kind of hitting the brakes on the cycle. And I think as long as the Fed is not hitting the brakes on the cycle, the market and the economy can deal with higher interest rates.
Now, can it deal with, you know, in two years or three years when the Fed gets back to a semblance of neutral? Will I have a different view. Yes. But I think, you know, in terms of next year and you told me, you know, that unemployment rate is 3.5%, inflation is 2.5%, 2.75%. And the Fed is at 87 and a half basis points on fed funds. My guess is stocks did. I'm not saying that, you know, it's another 25% year. But in that kind of backdrop, I think I'd rather over 12 months, I'd rather be a buyer.
Joe:
Jon Turk, thank you so much for coming on Odd Lots, always a pleasure. And I always, I always learn a ton. Have a happy new year and looking forward to revisiting. Maybe we'll get you on summer of 2022 to do the half-way mark.
Jon
Sounds good. Thank you so much for having me. Yeah. I mean, I think, you know, summer of 2022 is the big one. We’ll kind of know what the inflation endgame is.
Tracy:
Thanks so much, Jon.
Joe:
All right. Take care, Jon.
Jon:
Thank you.
Joe:
I love talking to Jon for many reasons, but one thing that really stands out to me is just his, his clarity.
Tracy:
Yeah. The thing I really like about Jon is that he kind of looks at everything on a probability distribution basis. So he's always trying to weigh tail risks on either side, whereas I feel like other people are going, you know, they're usually just focusing on one thing like, oh, runaway inflation and not necessarily looking at the other side of that probability distribution. But I thought, for instance, what Jon was saying about these sort of asymmetric risks to the inflation outlook, the idea that on the one hand, maybe we have four and a half percent inflation. On the other hand, maybe we get down to two and a half percent.
This is something that I've been thinking about with the piece I did on whack inflation. And it seems like yes, everyone's worried about inflation right now, but really what's going on is it's not necessarily relentless price increases. It's volatility in those prices and the difficulty of actually predicting where they're gonna go, given all these different factors around supply and what's going on well now with omicron variant.
Joe:
Yeah, absolutely. The way he talks about distribution is very useful. And specifically, I thought this idea it's like, okay, all year -- so we've had this big dollar rally and I thought that was really helpful having him explain that -- but all year we've had this sort of relentless, like maybe they'll hike a little bit more. Maybe we go from zero to one. Maybe we go from one to two. And this idea that once you get to around four possible hikes in 2022, once that becomes closure to say the markets base case or a possibility, then we really start to, it shifts in both directions. So we've had all this sort of like upward bias to the possibility range. We might still have that, but not much more. And then you start thinking about maybe three, you know, once you're at four, maybe three is more likely than five and hearing him explain why and that was really useful. And I think also he offers probably the clearest, in my opinion, the clearest explanation for why in a year where there's been so much anxiety about inflation, we've really just seen like nothing going on at the long end of the yield curve.
Tracy:
Yeah, absolutely. And I thought his point about inflation expectations was also very good because despite all the hand-wringing that we're seeing, you know, consumer demand has been relatively strong. Most people are saying that it's not a good time to buy things at the moment, which kind of suggests that they expect prices to come down, right?
Joe:
Yes. I don't know about you though. I have like five washing machines in my basement that I've been buying on expectations that I'll be able to flip them for more later. So yeah, I've definitely been hoarding consumer durable goods as investments. You're not doing that. Tracy?
Tracy:
You know, the sad thing is I can't even tell if you're joking or not.
Joe:
I am joking.
Tracy:
You might actually have five washing machines.
Joe:
I do not have five washing machines. I do have a washing machine though, which I feel extremely privileged to have in New York City. I've never had one in my apartment before.
Tracy:
Yeah. That is very convenient. Shall we leave it there before we start doing washing machine product reviews?
Joe:
Yeah. Although we could do that too, but yes, let's leave it. Let's leave it. Wait, actually wait, can I say one thing? Wait, wait, can I say one thing?
Tracy:
Yeah, of course.
Joe:
I did. Speaking of washing machines, I had the most 2021 problem, which is that a) I have like some smart washing machine. So I couldn't use it for a couple of weeks due to a software glitch. So a) that's a modern problem. But then b) I couldn't get a repair person for the washing machine for like over two weeks because of course, you know, labor market tightness and service market tightness and everything. So I do think the story of my washing machine is a sort of quintessential 2021 microeconomy story.
Tracy:
Maybe you need to write that up as an Odd Lots post.
Joe:
That's a good idea. I will do that this week. All right, let's leave it there.
You can follow Jon Turek on Twitter at @jturek18.