Yesterday’s Federal Reserve meeting can hardly be labelled as a non-event for the financial market. Jerome Powell's stubborn conviction that inflation will be transitory should make the market panic because no elements suggest that. On the contrary, the bloated Fed’s balance sheet and an unprecedented amount of budget stimulus point to sustained inflationary forces ahead.
Not to sound ancient, but let’s briefly talk about Milton Friedman and his teaching about monetary policy and inflation. According to the notorious economist, inflation is always a monetary phenomenon, and there is a lag in the effect of monetary policies. Therefore, inflation will be provoked by the exponential growth in the broad money supply we have witnessed since the Covid-19 pandemic. However, a lag in the reaction of monetary policies can lead the central bank to commit a policy mistake that the market will pay dearly.
In recent history, central banks committed a policy mistake that ultimately led to the Great Recession. Excessive accommodative monetary policies both in the US and Europe created macroeconomic imbalances, culminating with the 2007-2008 global financial crisis. At that point, authorities didn't take into account the macroeconomic risks that their accommodative policies entailed. We can say the same about this time around, too. Equity valuations are at an incredibly high level, and the stock market hits new highs every other week. However, high valuations do not reflect deterioration within the credit space caused by skyrocketing leverage.
The current economic environment is challenging not only because assets are riskier than before and more expensive. For the first time in history, the market lacks a safe-heaven. Interest rates remain at ultra-low levels providing no buffer in case of rising inflation (real interest rates are negative) and little upside in case of a market crash (US Treasury yields will not dive below zero).
Therefore, it’s easy to explain the chart below. Since the beginning of the year, the only assets that provided positive returns are high yield corporate bonds and TIPS. Why? The only option for bond investors is to find shelter among the riskiest assets. Junk bonds are the only ones to provide a yield high enough to build a buffer against inflationary pressures. At the same time, TIPS serve to hedge against inflation.