The chief of America’s biggest bank is worried. That’s bad news for all of us

At the start of this year, financial markets were pricing in as many as six US interest rate cuts. Now it’s only two. What happened?

Two related things have happened. US economic growth has been stronger than expected and US inflation has been more stubborn than expected.

JPMorgan CEO Jamie Dimon’s annual letter to shareholders says the threat of stagflation is very real.Credit: Bloomberg

Last Friday’s jobs data was typical of the way this year has been unfolding. The US created 303,000 jobs in March, far above the 200,000 economists had forecast. The unemployment rate edged down from 3.9 per cent to 3.8 per cent, again a stronger outcome than anticipated.

That has been the pattern so far this year, with the labour market and economy consistently outperforming expectations.

The flip side of the stronger-than-forecast growth has been an inflation rate that has been edging up, despite the Federal Reserve board maintaining its targeted range for its policy rate at 5 to 5.25 per cent – the highest level in more than 20 years. That range has been unchanged since last July.

The US headline CPI in January was 3.1 per cent. In February it was 3.2 per cent. The March number will be known on Wednesday but is forecast to be 3.5 per cent. While the inflation rate is way off the high of 9.1 per cent it hit in the middle of 2022, the recent trend is in the wrong direction.

The “last mile” of the fight against inflation, in the US and elsewhere, is proving more stubborn and bumpy than the Fed, or investors, had expected at the start of this year.

In the circumstances, it isn’t surprising that the optimism about rate cuts that was priced into markets has faded, even though the Fed chair, Jerome Powell, said only last week that the stronger-than-expected economy hadn’t changed the Fed’s expectation that a decline in inflation would allow for rate cuts this year.

The Fed’s famous “dot plot” of its members’ expectations has shown they expect three 25 basis point reductions in the federal funds rate (the equivalent of the Reserve Bank’s cash rate) before the end of the year.

The futures market is pricing in only two and, where a month ago there was an expectation that there was a better-than-even-money chance of a cut at the Fed’s next meeting (to be held on April 30 and May 1), now there’s a slightly less than even-money probability of that first cut occurring at the June meeting.

The bond market reflects the shifts in sentiment, with both two and 10-year bond yields steadily edging up this year. The two-year yield at the start of the year was 4.25 per cent. It’s now 4.79 per cent. The 10-year yield was 3.88 per cent. It’s now 4.42 per cent.

While both are off last year’s highs, the trend isn’t consistent with the soft landing with a declining inflation rate scenario for the US economy that prevailed at the start of the year.

Sharemarket investors have largely ignored what’s happening in the bond market, instead either excited by the continuing developments in artificial intelligence or fearful of external events.

The market wobbled last week as heightened tensions in Gaza and OPEC+’s decision to maintain its production cuts drove oil prices above $US90 a barrel.

While the US is now a net exporter of oil, higher oil prices mean higher petrol prices, which equals higher headline inflation rates and therefore higher-for-longer interest rates.

The next interest rate cut in the US may be further away than we think. Credit: AP

There are those who believe that both the Fed and the markets could be badly wrong about the outlook for inflation and interest rates.

In his annual letter to JPMorgan Chase shareholders, Jamie Dimon, for instance, said the biggest US bank had ongoing concerns about persistent inflationary pressures and had considered a wide range of outcomes – interest rates as low as 2 per cent and as high as 8 per cent – to manage its own rate exposures.

While many key economic indicators today were good and possibly improving, there are many inflationary pressures that were likely to continue, he said, citing world remilitarisation, restructuring of global trade, the capital needs of the green economy and possible higher energy costs among them.

The threat of the stagflation Dimon sees as a worst-case risk to the US economy isn’t one confined to the US.

He said it was important to note that the US economy was being fuelled by large amounts of government deficit spending and past stimulus.

“This might lead to stickier inflation and higher rates than the markets expect,” he said.

Economically, the worst-case scenario would be stagflation – continuing high level of inflation, high interest rates and low growth.

“Equity values, by most measures, are at the high end of the valuation range and credit spreads are tight. These markets seem to be pricing in 70 per cent to 80 per cent chance of a soft landing – modest growth along with declining inflation and interest rates. I believe the odds are a lot lower than that,” Dimon said.

Even though the US sharemarket is off its highs, it continues to price in near-perfect outcomes, up about 9 per cent so far this year and almost 29 per cent higher than a year ago, even as bond yields have risen, which, conventionally, isn’t good for equities.

The level of uncertainty inherent in JPMorgan’s interest rate scenarios suggests that the sharemarket is extremely vulnerable to anything other than perfect outcomes.

What happens in the US economy and markets matters for the rest of the world. Other central bankers are very aware that they can’t drift too far from the rate structure that the Fed sets without the interest rate differentials risking significant capital outflows and currency depreciations that would add to their own inflation rates.

The likelihood of later and fewer US rate cuts this year than the markets had anticipated – and the prospect that they might even shift higher, if JPMorgan’s more pessimistic outcomes were to occur – will limit other central banks’ flexibility to some degree, even if their economic circumstances are quite different. The threat of the stagflation Dimon sees as a worst-case risk to the US economy isn’t one confined to the US.

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