To that end, the strength of the U.S. Dollar will be important to watch, as a stronger dollar exerts downward pressure on inflation (commodities and imports become cheaper). The actions of other central banks around the globe will also be important to monitor, as monetary easing maneuvers by these banks could strengthen the dollar. U.S. wage pressures will be another metric to watch, as anecdotal evidence of upward wage pressures are beginning to be seen in the hard data.

In order to help inform their conclusions, investors should pay attention to market-related measures of inflation—such as zero-coupon inflation swaps and the Fed’s calculation of 5 year forward 5 year inflation expectations derived from the TIPS market.

If it is the case that the market’s expectation for the pace of hikes is likely to be quicker than is currently priced in (the OIS curve), we would expect three outcomes:

  1. The U.S. Dollar would appreciate more.
  2. Commodities and possibly emerging markets would suffer.
  3. U.S. yields would rise more than currently expected.

We do not believe these outcomes to be the “base case”, as this Fed has proven to be relentlessly dovish. But it’s important not only to have a contingency plan in place if events unfold in that manner, but also to know what market-based signals and data to pay attention to in order to anticipate it.

Keep your eyes on inflation, folks.

 

Ronald Saba is the Senior Managing Director of Investment Management and Chief Investment Officer at Horizon Investments, a participant in the ETF Strategist Channel.