A Radical Thought for Investors

By James Mackintosh Features Dow Jones Newswires

There are two ways to trade the Fed. One is to look at what the Federal Reserve says, compare it to your own forecasts for inflation, growth, productivity and wages, and decide whether Fed Chairwoman Janet Yellen was right to show a flicker of hawkishness on Wednesday. This is what almost every major fund manager does, investing huge amounts of time and effort in econometric analysis. Most is wasted.

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The alternative is to look at the market's assumptions to see what's being ignored. Right now, it is the reflation trade, abandoned along with Donald Trump's credibility on Wall Street.

After the election investors bet big on Mr. Trump and the Republican Congress adopting growth-friendly tax cuts, spending boosts and cuts to red tape. The Fed, they thought, wouldn't derail growth. Since shortly after the Fed's mid-December increase, investor assumptions have completely reversed. A divided Congress won't be able to do anything, the Fed might be making a mistake to tighten and inflation isn't just resting, it is in a coma.

The reverse of the reflation trade is visible in equities, bonds and the economy. How one feels about it depends on a critical shift by the Fed, from being "data dependent"--backward looking--to return to the traditional central bank approach of setting policy according to what it expects to happen, not what's already happened.

The data on which the Fed no longer depends have indeed shown little of the dynamism needed to justify rate increases on a backward-looking basis. Wages have been rising fast in some sectors, but overall are growing only a little above inflation, despite unemployment well below the Fed's estimate of what counts as full employment (which Fed policy makers keep cutting, with the median estimate down again on Wednesday to 4.6%). Inflation remains stubbornly below the Fed's target. And economic data has been disappointing, with the most unpleasant surprises compared with forecasts in more than two years, according to a Citigroup index.

Yet, all this and more is now priced in. The bond market's expectation for inflation in the long term is the lowest since before the U.S. election, and at 1.8% is below the Fed's target. The 10-year Treasury yield is back down to where it was the day after the election, and on Wednesday its post-Fed rise wasn't enough to offset its drop in response to earlier disappointing inflation figures. As a result, the closely watched gap between 2-year and 10-year yields dropped below 0.8% for the first time since last summer's fears of deflation. In the past when it is fallen below zero a recession has almost always followed.

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Back in late November and December I was skeptical that Mr. Trump could deliver enough to justify the massive run-up in cyclical stocks and bond yields, which seemed to be based on wild overexcitement from investors. Now those same investors expect the administration to achieve nothing and have returned to their pre-election gloom about the economy. Again, the received wisdom seems to have gone too far, and again relies on too much guesswork.

Investors should accept that they know far less about what's likely to happen to growth, wages and inflation than economists like to make out. Assumptions about the level of full employment or how inflation responds to full employment are little better than guesswork.

The Fed may turn out to be right this time, and wages and then inflation may pick up as job vacancies prove hard to fill. Further, the Republicans will surely soon realize that they have to pull together and pass something--anything--on tax and red tape to avoid going into next year's midterm elections with nothing to show voters.

Economic and political analysis is worth trying. But the hurdle to success for the reflation trade is much lower, and the idea that Mrs. Yellen might be right this time is worth a punt.

Write to James Mackintosh at James.Mackintosh@wsj.com

(END) Dow Jones Newswires

June 15, 2017 08:54 ET (12:54 GMT)