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Fed vs. inflation: What's changed coming out of the pandemic?

Stocks are mixed (^DJI, ^IXIC, ^GSPC) Tuesday morning after February's Consumer Price Index (CPI) reading showed headline and core inflation to have risen slightly year-over-year. Should this news be expected to deter the Federal Reserve from any future interest rate cuts?

Easterly EAB Risk Solutions Global Macro Strategist Arnim Holzer sits down with Yahoo Finance in-studio to discuss what post-pandemic inflation readings are indicating to Fed officials, investors, and equity markets at large.

"The reaction post-pandemic has been a very different reaction from what we've seen in prior economic situations. As a result, the narratives that we expect — which is the Fed to raise rates, inflation to come down — is not operating according to those narratives. So we think, actually, that the Fed is right to be data-dependent, but not necessarily to expect the same narrative, the same script. We think that spells volatility. We think that spells a very different kind of diversification. And we really think that investors need to focus on the long-term here..."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Editor's note: This article was written by Luke Carberry Mogan.

Video Transcript

SEANA SMITH: Stocks mixed on the heels of that inflation print this morning showing that prices remain sticky. Now, the CPI headline number climbing at 3.2% during the month of February, which is well above the Fed's inflation target. Now for more, we want to bring in our Arnim Holzer. He's Easterly EAB Risk Solutions Global macro strategist. Arnim, it's great to have you here at the desk with us. So help us make sense of the market action that we've seen today in reaction to this report.

ARNIM HOLZER: Well, I think the market's still trying to digest what is actually a very complex and nuanced topic. There's huge divergences between what the market would like to see in terms of inflation under control to give small and mid-cap companies more room against refinancing. But at the same time, they don't want the economy to go into a tailspin. And so while longer term this data may actually be supportive, it's very confusing to the Fed and therefore to some of the component small and mid-cap stocks.

BRAD SMITH: Is the Fed focusing on the wrong components, then? I mean, when we think about what came through this report, the index for shelter rising in February, gasoline rising, those two index contributing over 60% of the monthly increase in the all items index.

ARNIM HOLZER: Right. When you go back to the genesis of this entire issue, which is the pandemic, the reaction postpandemic has been a very different reaction than what we've seen in prior economic situations. So as a result, the narratives that we'd expect, which is Fed to raise rates, inflation to come down, is not operating according to those narratives. The market keeps expecting those narratives.

So we think actually that the Fed is right to be data dependent but not necessarily to expect the same narrative, the same script. We think that spells volatility. We think that spells a very different kind of diversification. And we really think that investors need to focus on the long term here, not necessarily each of these numbers but how you build resiliency into portfolios.

SEANA SMITH: Arnim, real quick before we get your playbook here, just how problematic that rise that we saw once again in supercore inflation? How problematic is that for the Fed?

ARNIM HOLZER: Well, I think it's very problematic because, ultimately, what it says is the prior playbooks that they've used that they've counted on, which is to raise rates and the transmission into the real estate sector, into the consumption sector of bringing down demand is not necessarily operating the way they expect.

And so if it's not operating the way they expect, there's only two solutions. One is to assume they have to wait longer. Or two, which I think you will see this summer at Jackson Hole, I think you'll see some discussion around has the equilibrium rate actually risen. And so--

SEANA SMITH: Do you think it has?

ARNIM HOLZER: I think there's very good evidence that postpandemic there have been changes to demand curves. I think there's also been a change to globalization to the need to really manage supply chains. We're not in a globalized world as we were prepandemic. And so those issues do create somewhat of a different environment.

BRAD SMITH: What is the playbook then for a data dependent Fed in this environment that we're in right now?

ARNIM HOLZER: Well, I think, number one, they don't want to act too harshly. But at the same time, they don't want to act too beneficently. They don't need to bring the punch back to the party, which is what I think the equity markets want.

BRAD SMITH: We do.

ARNIM HOLZER: If you look exactly-- no, completely right. If you look at the way equity markets have behaved and if you look at the way the Fed funds futures have behaved, they're still calling for eases this year. Now, there are some pretty followed organizations that are beginning to say no. The dot plots that the Fed have of 2 is actually fairly reasonable, but that doesn't get you back to what markets would like to see in terms of a normalized yield curve.

It's still inverted 40, 50 basis points. That doesn't help you in terms of sector rotations. What IWM, what small cap, what a lot of managers who are trying to buy value are looking for is that opportunity for a positively slope yield curve. When you don't see that, that spells that there's still some risk in the market even though volatility, the VIX, is still about 14.5, I would say that that's underplaying the fact that we're still in this inverted yield curve, and that's not giving you that all clear signal that you'd like to see.

SEANA SMITH: What about the action that we're seeing in the Mag Seven names? We certainly have started to see some weakness over the last couple of days, not to make too much of just a handful of trading days and the trading action that we're seeing there, but do you expect maybe to see more pressure on some of the names that led last year's rally?

ARNIM HOLZER: Well, if you believe that the Fed wants to be your friend, then you do need to start rotating to small and mid-cap stocks. If you don't believe that in the middle of a refinancing environment where the Treasury has got to do a lot of refinancing today-- witness we have a big refinancing coming up that might have some difficulty because of this inflation data-- you would normally make that rotation.

If you don't see that rotation, then you shouldn't necessarily abandon the big cash holding names that have AI are not the sweet spot of organic growth. If you do believe that we're going to get back to a normalized yield curve, then it would make sense to maybe take some profit and reallocate. We're more of the mind that there's volatility.

That this has been a somewhat uncertain, maybe even a premature rotation. But there are places you can rotate that still benefit from this environment. But willy nilly selling all the big cap stocks when you're not sure that you're really going to get that normalized yield curve, it may be premature.

BRAD SMITH: Arnim Holzer, who is the Easterly EAB Risk Solutions Global macro strategist, joining us here in studio. Thanks so much for taking the time this morning.

ARNIM HOLZER: My pleasure.

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