In financial markets every price tells a story about what investors implicitly believe could be the most likely scenario for the future. Here is what market prices are telling us about investors’ expectations for 2022 and beyond.
Inflation: Investors anticipate inflation to average around 3.5% in 2022, down significantly from the nearly 7% pace in 2021 but still well above the Federal Reserve’s theoretical target of around 2%. The January 2023 Treasury Inflation Protected Securities (TIPS) have a yield of -3.05%, whereas the standard U.S. Treasury maturing that same month has a yield of +0.46%, implying inflation could be around 3.5% in 2022. Looking further into the future, the break-even inflation spreads between TIPS and standard (nominal) U.S. Treasuries imply that investors expect inflation at 2.9% in 2023, and annual inflation at around 2.5% from 2024 to 2027. Crucially, investors see long-term inflation expectations (from 2028 to 2051) to be anchored around 2-2.25%.
This has two implications. First, to achieve 3.5% inflation in 2022, the monthly figures would have to average around +0.3%. Since April 2021, monthly inflation has often been much higher, with readings often in the +0.6-0.9% per month range. Continued upside surprises could upset the expectation of inflation averaging 3.5%.
Second, long-term inflation expectations remain well anchored. Investors appear to believe that the recent spike in inflation could prove to be temporary and that 1970s-style inflation is unlikely. Moreover, investors appear to believe that the risk of inflation rising significantly above 2% in the long run is not much greater than the risk of inflation significantly undershooting 2%.
Interest Rates: Part of the reason why long-term inflation expectations remain so well anchored is that investors anticipate that the Fed will tighten monetary policy enough in 2022 and 2023 to head off a longer term rise in inflation. As of early January 2022, investors have priced that the Fed would most likely hike rates three times in 2022 followed by a further two or three rate hikes in 2023.
Beyond 2023, SOFR futures imply a long-term equilibrium Fed policy rate of around 1.8-2.%, just below the anticipated rate of inflation of 2-2.25%. This implies that investors see long-term equilibrium real interest rates at being close to zero or even slightly negative.
This reflects an expectation that the 2020s will eventually come to resemble the 2010s, when inflation rates remained stable at around 2% and interest rates eventually rose to the level of inflation. Even so, this is still a departure from the period from 1980 to 2008 when interest rates were typically a few percent above the rate of inflation.
The market’s view of equilibrium interest rates may be influenced by the level of debt in the economy. As debt levels have risen over the past 40 years, interest rates have tended to trend downwards. This could be because inflation rates have generally fallen (until 2021 anyway). It could also reflect a belief on the part of investors that high debt burdens can only be managed with interest rates close to or below zero in real terms. The fact that the overall leverage in the economy rose sharply during the early stages of the pandemic may be reinforcing the fear that disinflationary pressures could re-emerge and the belief that the Fed can contain inflation with relatively small changes in interest rate policy.
Corporate Earnings and Dividend Payments: S&P 500 Annual Dividend Index Futures offer a glimpse into investor expectations for corporate cash flows for the next decade. For 2022, investors appear to anticipate 5.5% growth in dividends, which, given the break-even inflation spreads, implies dividend growth of about 2% in real terms. Investors see modest further gains in nominal dividends between 2023 and 2032, while they expect dividends stagnating or falling slightly in real terms over the next decade.
Commodity Markets: Another reason why investors anticipate a moderation in the pace of inflation may have to do with commodity prices. Many of the commodity markets are in backwardation, meaning the futures contracts expiring far into the future are trading at lower prices than futures contracts expiring in the near term. For example, corn and soybean contracts expiring in March 2023, are trading at values about 7% lower than contracts expiring in March 2022.
Nearby contracts for West Texas Intermediate crude oil are trading around $77 per barrel as of early January, but those further into the future are trading lower, like the December 2024 contract trading below $65. It’s a similar story for other energy products such as gasoline and ultra-low sulfur diesel. The same is true for certain metals, notably hot rolled coil steel.
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