The market certainly blew off some steam in the days after my last, cautionary Perspective on inflation risks. It felt like an important moment. If the economy is a machine, financial markets are its pressure-release valves and market levels are its pressure gauges. When markets let off steam, it’s a sign that eyes have turned to those gauges, watching for needles moving into the red.

In our most recent Asset Allocation Committee (AAC) Outlook, we anticipated that the transition into a new environment of rising inflation expectations, rising rates and faster growth would take us into more normal volatility conditions. The turbulence we got a month ago came earlier than we expected, but it was a characteristic response to late-cycle inflationary growth. Risky assets have bounced back and implied volatility has settled to historically normal levels of around 15 — 20, neither as high as in early February nor as low as through 2017. The risk of recession this year appears remote, and investors are still buying the dips rather than becoming defensive.

But now, unlike last year, all eyes are on the dashboard.

Three key pressure gauges

I have been on the road a lot this year, from the US. Great Lakes to Japan to Europe, and investors have nearly always asked me the same question: Which gauges are we watching most closely, and where do we think the red zones are?

Of course, our dashboard is crammed with instruments monitoring market prices, equity valuations, corporate earnings and a raft of macroeconomic releases. Three gauges are particularly important to us right now, however.

The trigger for the sell-off a month ago was an unexpectedly strong US wage-growth print, which followed an already substantial rise in bond-market break even inflation rates. The Inflation Expectations Gauge is front and centre, then: Once the 10-year US break even rate breaks through 2.5 per cent, things start to get interesting, and it could cause the Federal Reserve to adjust its policy; but our research indicates that inflation has had to rise above 3 per cent before it has seriously affected important market relationships.

The Interest Rates Gauge is right next door. How high can rates go before the market decides they have overshot? We think 3.25% for the 10-year US. Treasury yield is tolerable. A rapid rise to 3.5 per cent, however, and stress levels in credit markets could rise, valuations in equity markets may have to be revised, and the response could bring forward the end of the cycle.

Our third key gauge monitors US dollar exchange rates. If the dollar swoons further, past 1.05 against the Japanese yen or 1.30 against the euro, that would pose a significant headwind to corporate earnings in Japan and Europe, potentially eliciting disruptive monetary policy changes in Tokyo and Frankfurt. In the less likely event that the dollar rapidly strengthens, when does it start to weigh on commodity prices or export-driven emerging economies that owe a lot of dollar-denominated debt?

A complex machine

At Neuberger Berman, we see no obvious reason why this mature phase of the current economic cycle should not persist for some months, perhaps into 2020. All we need is well-behaved inflation, a predictable pattern of modestly rising interest rates and an orderly unwind of central bank balance sheets.

Markets are seldom orderly, however, and the economy is a very complex machine. We expect it to run hotter and faster this year, and that is why investors are now watching its pressure gauges more intently — for signs that it is running too hot or too fast. If and when those needles move into the red, it may be time to adopt a more defensive portfolio position to make sure we are prepared for when the market really lets off some steam.

— Erik Knutzen, Chief Investment Officer — Multi-Asset Class