Federal Reserve Chairman Jerome Powell’s retirement of the term “transitory”According to Cole Smead (president and portfolio manager at Smead Capital Management), inflation can have a surprisingly negative impact on risk assets.

Powell stunned markets this week when he changed his previous tone about inflation and told U.S. lawmakers it was “probably a good time [to retire] that term (transitory] and try to clarify what we mean.”

As inflation has been consistently exceeding central bank target, there is increased speculation that central banking might be forced to raise monetary policy sooner than they expected. If the Fed admits that inflation is more likely than anticipated, investors have sought to determine where and how it might tackle it.

Smead stated that Powell’s statements were a “meaculpa,” which is an admission that Powell was wrong. It also indicated that the possible impact it had on Fed policy or the asset values might not be appreciated.

According to Smead, “In essence, people buy the U.S. Treasury 10-year note because they feel insulated at the shorter end of the curve.”

“Most of the Equities were punished in the past couple days and now we can discuss the Omicron [Covid variant]It’s not, however, I believe it’s the people that are somewhat afraid of what the Fed might do to them.

Smead stated that those who buy “quality blue-chip businesses” are more likely to consider longer-term investments such as Microsoft or Apple. However, they may not be as stupid as purchasing the 10-year now.

The yield curve is a graph that shows how U.S. Treasury Notes’ short-term and longer-term interest rates relate to each other. The interest rate is usually higher for longer durations. However, when rates are closer together, the yield curve becomes flat. Inversions of the curve are usually seen as warning signals for the market.

As investors speculated about Fed early rate rises to curb inflation spiralling, the yield curve has flattened. The prices and yields are in direct proportion.

This is in spite of strong job numbers and PMI (purchasing manager’s index) readings coming from the U.S. which indicate that economic recovery remains on track.

Smead explained that investors were “looking for somewhere they can hide in the interim” and Powell’s change in tone was not consistent with investor expectations.

Smead explained that they treated the Fed like a omnipotent ship captain, and so long as the captain was stewarding the ship, everything would be okay.

“Now that liquidity has been eliminated, the question remains as to how rapidly and how far, which I think is a mystery to most people.”

He argued that the U.S. consumer is seeing “incredible inflationary pressures,” and real yields — interest rates adjusted to remove inflation, therefore representing the real cost of capital to the borrower and the true yield to the lender or investor — are going to spike if the Fed tightens.

Smead stated that real yields will change from their worst levels since 1974 to meaningful yields. This is a catastrophe for risk assets.

There’s more to it

Smead’s bearish views are not shared by everyone. On Thursday, Mislav Matejka, Head of Global Equity Strategy at JPMorgan, stated that the Fed is simply giving itself some flexibility and keeping liquidity on hand while also accelerating its tapering in order to not be “behind” the curve.

Matejka stated that to be bullish on the equity markets, one must assume that central banks will focus solely on inflation rather than growth. That’s not how you usually make money.

“Most central banks serve as put options for equity markets. They are available to provide support in the event of liquidity loss or shocks. It is not common to argue that the central banks will cause equity market weakness in developed markets next year. This has been proven wrong many times before.

JPMorgan believes that, with inflation rising at a multidecade-high in major economies, it will be over by 2022. This makes the Fed feel more confident about the pace at which it is reducing its stimulus package.

Matejka pointed out that indicators for stickier inflation such as the Baltic freight and thermal coal price in China are already “already rolling.”

“In three to six month’s time, it will be difficult to determine if the Fed needs to become more hawkish in comparison to the market’s pricing. He said that the market has already priced in almost three more hikes for next year.

Matejka explained that the bear scenario will only be realized if markets conclude the Fed has committed a policy error by tightening no matter what, even when there is disappointing growth.

JPMorgan does believe that growth will be greater than expected in 2022. The market, however, has priced in these concerns in the last six months as evidenced in flattening yield curves.

Matejka explained that this could actually be easing as the market realizes central banks in developed countries, which are the key to Fed or ECB’s operations, don’t need to become ever more hawkish. That allows for the equity markets to enjoy much greater upside.