Lack of market volatility tied to depressed Inflation?

A rapid, unexpected change in interest rate expectations could lead to a dramatic increase in market volatility, which will result in sell-off in risk assets according to Nomura. What would inspire such a dramatic change in interest rate expectations? The answer is simple, a rapid increase in inflation (something few analysts expect) would be the catalyst that would set off a sudden change in Federal Reserve policy.

It is no surprise that many analysts and economists have given up on inflation. After many quarters of negative inflation surprises, confidence in inflation forecasts have dwindled, and future inflation expectations have fallen. According to Nomura research analyst Kevin Gaynor, this environment has increased the risk that inflation will surprise to the upside.

Depressed Inflation Correlated To Market Volatility?

Traditionally, inflation begins to emerge when unemployment declines to a certain threshold and employers have to chase employees with the prospect of higher wages. In this cycle, there has been no such development and evidence suggests that to create sustained inflation rates, unemployment will need to fall further than previously thought.

This leads to the issue of consumer confidence. Consumer confidence has a strong negative correlation with unemployment so a longer growth cycle, with a deeper employment trough, may be the "perfect recipe for even higher highs in valuations and lower lows in volatility." Unfortunately, higher market valuations and less volatility on the way up may mean more volatility and lower lows on the way down. As the relationship that defines inflation and employment has apparently changed in this cycle when the cycle turns "we should expect a more violent labor market outcome than in previous episodes." This outcome may require a "large adjustment in asset prices to occur" as it unfolds.

A sudden increase from the current depressed Inflation level is not likely unless there is a rapid increase in import prices or commodity prices spike higher. The bigger issue Gaynor notes is the scale of layoffs that are likely to come when the economic cycle turns, and businesses tried to rebuild profit margins. After a prolonged period of job creation thanks to the benign inflation environment, when the adjustment comes it will be significantly more painful than prior episodes.

"Higher inflation should not be a surprise then. But after a long period of negative surprises and lower inflation expectations, it probably will be. We should expect a slow and steady increase unless import prices and commodity prices move higher too. The bigger concern should probably be what that economic state means for risk asset valuations at the point the cycle turns given the unemployment increases that will probably be required for businesses to rebuild profit margins in the next downturn."