Enguerrand Artaz

The importance of words

The biggest drop in US 10-year yields since the panic at the start of August 2024, the most significant easing in German 10-year yields since mid-June, a 3.7% surge for the Magnificent Seven and one of the biggest daily US stock market rises in the last two years – the reaction of markets after the publication of US inflation figures for December suggests that these came as a massive upside surprise, sufficient to radically change the narrative on inflation. Yet although there was certainly some element of surprise, it was minimal. Overall inflation came in at 2.9%, perfectly in line with consensus expectations. Meanwhile, core inflation was 3.2% versus a forecast of 3.3% – the actual figure was 3.248%, very close to being rounded up to 3.3%.

So how can we explain such a powerful reaction on markets to such a meagre surprise? In principle, the answer can be found in the extreme sensitivity of investors – particularly bond investors – which has been gradually growing since the autumn, in parallel with a sharp rebound in interest rates. This move began on the back of the prospect of victory for Donald Trump with a programme that was felt to be inflationary, was then amplified by his wide margin of success in the presidential elections, echoed in the restrictive stance of the US Federal Reserve (Fed) following its December meeting, and culminated with the publication of very sound US employment figures at the beginning of January. During this time, investors revised down their expectations of rate cuts by the Fed from six to less than two in 2025. And US 10-year yields moved from 3.6% in mid-September to 4.8% in mid-January. A spectacular rise that reflects the return of inflation worries to centre stage.

However, it’s hard to uncover the reason for this tightening if we take a dispassionate view of the inflation figures. Of course, although it has entered its last leg, the pace of disinflation has slowed, with prices ticking up slightly between August and November. However, the underlying trends have barely budged and remain favourable. Housing inflation – the largest component of residual inflation which is reflected in the figures with a substantial time lag – continues to decline. The same is true of the Fed’s primary focus in recent months, services excluding housing, where price rises continue to slow. As for the slight uptick in inflation in recent months, it has mainly been fuelled by structurally volatile components (airline tickets, clothing) or one-off hikes, in particular used car prices, after a long period of decline. From this perspective, the inflation figure for December – although perceived as extremely positive by markets – is simply more of the same. The bottom line is that disinflation is continuing in the US, a little more slowly, but surely.

This chain of reactions basically reflects the importance of investor psychology on the perception of economic data, and even more certainly, the importance of certain statements on investor psychology. This applies to statements made by Donald Trump of course, with the emphasis on increases in customs tariffs, the massive expulsion of migrant workers, and another cut in corporation tax – key measures perceived as being likely to jump start inflation. It’s also the case for statements from Jerome Powell which, after the meeting of the Fed in December, reflected the reduced confidence of a central bank worried about the impact of the policies of the incoming president on the trend of disinflation. The central bank is clearly worried enough to include this impact in its economic forecasts, despite the fact that the measures that the new administration will actually adopt are still far from clear.

And lastly, we should not forget the recent speech of Christopher Waller, Member of the Federal Reserve Board of Governors. Traditionally seen as a hawk[1], the former vice president of the Federal Reserve of Saint Louis made some particularly accommodative statements, indicating that the Fed could potentially make up to four rate cuts in 2025, and not excluding a rate cut at its March meeting. This amplified the easing in bond markets, that began with the positive surprise on inflation. Several days earlier, he had indicated that he was confident that disinflation would continue and that the Trump administration’s policy on trade tariffs would have little impact on inflation. Given the influence of Christopher Waller within the Fed, this may well represent a type of “after-sales service” by the central bank, concerned by the level and direction of long rates, and keen to see markets reengage with a more rational approach.

For investors, this chain of events is a timely reminder. The statements of influential people – political leaders, central bankers, etc. – and shifts in market psychology create short-term volatility, which can potentially be put to good use. But in the longer term, economic reality – in the current case, the continuation of disinflation – will generally provide a reminder to correct excesses. The trick is to stay on course, despite frequently overexuberant market reactions.

The opinions cited are those of the fund manager. LFDE shall not be held liable for these opinions.

Final version of 17 January 2025 – Enguerrand Artaz, Fund Manager, La Financière de l’Échiquier (LFDE)
[1] A term used for central bankers in favour of restrictive monetary policies, in contrast to doves, who tend to prefer more accommodative policies.