What if the Fed succeeds in raising inflation expectations? UBS

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3) What if the Fed succeeds in raising inflation
expectations?
The stated rationale by the Fed for potential QE2 is to anchor inflation
expectations, which are considered too low. However, if inflation expectations
were to rise, long-term bond yields could also rise, leading to a higher cost of
capital. Could the Fed derail the bull case for Asian equities by achieving its
goal?
Historically, rising inflation expectations in the US have been associated with
positive equity market performance in Asia. In Chart 5, we show how the MSCI
Asia ex Japan index performed in the future 6 months as US inflation
expectations (implied by 10-year TIPS) changed. During 1999, 2003 and 2009,
when there were sustained ‘step changes’ towards higher expected inflation,
markets have performed well.
This is because those specific step changes reflected rebounds from recessions
or economic slowdown. Equities were driven by prospects of stronger economic
growth, notwithstanding higher cost of capital. If in the current environment the
Fed succeeds in generating expectations of stronger growth and as a result
higher inflation, this should be positive to markets.


What about ‘bad’ inflation?
Where there is a risk is if the market fears that inflation will get out of control.
This could lead to a sell-off in the Treasury market. This is clearly a bad
outcome for Asia ex Japan equities.
To us, this would seem to be a ‘tail’ risk, at least in the near-term. There is little
confidence that the market is losing confidence in US dollar assets judging from
significant compression in bond yields year-to-date, despite the US dollar
weakness more recently. We show in Chart 6 the 10-year yields on inflationprotected
Treasury bonds, which have fallen from 3.8% at the beginning of the
year to 2.7% now. Longer term, it could become a greater risk, especially if the
Fed were seen as ‘monetising’ the fiscal deficit.


A repeat of 1994?
What could happen if the bond market corrects but not due to a loss of
confidence in the Fed? There have not been many episodes in the past 20 years
where the Fed triggered a sell-off in bonds by raising interest rates to dampen
inflationary pressures, rather than just ‘normalising’ rates after it has cut interest
rates to very low levels in response to a crisis (the collapse of LTCM in 1998,
for instance). On Table 3, we listed the instances going back to the 1970s where
the Fed engineered a sell-off in the bond market. Asia ex Japan equities
performance was mixed, though in 1994 it was negative, in part because the
MSCI Asia ex Japan index doubled during 1993 and started 1994 from a high
base.


Implication to Asian equities
From an Asia ex Japan equities perspective, the Fed fighting deflation is positive,
as long as there isn’t a ‘run’ the US bond market. Our long-held view is loose
monetary policies will drive asset prices up in Asia, and as long as the Fed is
worried about deflation liquidity conditions are likely to stay loose. Where there
could be headwinds are if the Fed starts to worry about inflation and reverse
policies, or if the Fed fails, and have to resort to even more unconventional
measures. Both scenarios are possible but we are still a long way from them.