By: Jim Brilliant, CFA® Chief Financial Officer, Co-Chief Investment Officer, Portfolio Manager, Principal.
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- We believe the Federal Reserve (the “Fed”) is in a very difficult position between combatting inflation and trying to avoid a recession.
- Alleviating supply constraints, which contribute to the structural source of inflation, requires substantial investment in new capacity. A recession would severely limit the needed investment, further limiting supply.
- A recession would also cause substantial fiscal deficits requiring additional U.S. debt financing. Another round of enormous fiscal and monetary stimulus would be needed to restart the economy. We believe the Fed understands a recession could create an even larger inflation problem down the road, complicating its job.
- The Fed’s action to control the cyclical part of inflation by tempering demand through higher interest rates is starting to take hold.
- Mortgage rates, near 7.0%, have led to fewer housing sales and reduced home prices.
- Used vehicles sales volumes and prices appear to have peaked and are rolling over.
- Commercial real estate development, often financed with floating rate debt, also looks to be slowing.
- Consumer spending is beginning to slow.
- Offsetting this cyclical part of inflation are a host of fiscal spending programs like college debt forgiveness, the Chips Act, and the Inflation “Reduction” Act.
- Additionally, de-globalization and the reshoring of manufacturing will likely keep labor tight, keeping upward pressure on wages.
- Despite the many cross currents, inflation remains sticky as seen by the Core Consumer Price Index (“CPI”) and the Atlanta Fed’s Sticky Consumer Price Index ("CPI").
- Until these indexes begin to roll over, we expect more rate hikes.
- The Fed raised interest rates by another 0.75% at its November meeting, bringing the federal funds rate to 4.0%. We believe this will be followed by another rate hike of 0.50% to 1.0% over the next several meetings.
- As the recent rate hikes begin to take hold, we expect the cyclical part of inflation to moderate. This should bring overall inflation modestly lower, at which point we expect the Fed will pause raising rates as it attempts to avoid a recession, with the hopes that supply constrained industries will continue to invest in needed capacity. In this scenario, inflation is modestly lower than current levels, but higher than the Fed’s 2.0% target for several years. Overall, growth remains slow as the Fed moves between containing inflation and avoiding a recession.
- With this backdrop in mind, for our clients that have balanced or fixed- income accounts, we continue to hold short-maturity Treasury bonds and are opportunistically buying short-term corporate bonds. We will extend duration only at a time when longer-dated Treasury bonds pay adequate returns relative to inflation and corporate bond spreads widen such that they sufficiently discount a risk of a weaker economy.
Interest Rates & Inflation
Interest rates continued a steady ascent during the recent quarter ended September 30, 2022. The shortest-dated Treasury bond yields accelerated most and are now higher than the medium and longer-dated Treasury yields.
Over the past 12 months, two-year Treasury yields have increased from 0.25% to 4.28%, as the Fed reduced its buying of short-term Treasuries (i.e., quantitative tightening), raised the short-term fed funds rate to 4.0%, and signaled its intention to continue to meaningfully raise interest rates for the remainder of the year.
Overall, Treasury bond yields reached new highs for 2022. Over the past quarter, 5-year Treasury bond yields are up 35%, 10-year Treasury bond yields are up 27%, 20-year Treasury bond yields are up 19% and 30-year Treasury bond yields rose 18%. (See Chart 1). The speed at which bond yields have risen caught most investors off guard. With bond prices moving in the opposite direction as bond yields, its easy to see how the rapid increase in yields led to a rapid decline in bond prices. As an example, the Barclays Aggregate Bond index, with an average duration of approximately 6 ½ years, has declined by 15.9% year-to-date, while the shorter-duration bonds that we’ve favored have been flat-to-down low single digits.
With government interest rates rising, corporate bond index spreads across the yield curve continued to compress. For the past 40 years, spreads between corporate bonds and Treasury bonds initially compress near the end of a business cycle before dramatically increasing.
Currently, spreads across the yield curve continue to compress tracking much like previous inflection points. During this period, bond investors have generally done well to remain in high quality, short-duration bonds until corporate bond rates reset higher, creating opportunity to extend duration at much higher yields.
We anticipate the spread between investment-grade corporate bond yields and 10-year Treasury bond yields to eventually rise well above the historic average as recessionary pressures mount. (See Chart 2)
As seen on Chart 3, inflation continues to run hot. The most recent reading for October shows the all-items CPI, the red line on the chart, is running at 7.75% on a year-over-year basis. This is down from June’s peak 9.02% rate.
The October figure for Core CPI (i.e., less food and energy), the purple line on the chart, is running at 6.3% year-over-year, up from June’s 5.92%, but down slightly from September’s 6.6% rate. The Fed pays particular attention to the Core CPI figure, and the fact that it reached a new 40-year high has the Fed concerned it’s losing the inflation battle. After September figures were released, Fed governors from across the country went on speaking tours forecasting aggressive rate hikes over the next few months, with many suggesting the fed funds rate might reach 5.0%, up from the then current 3.25%. In its subsequent November 2nd meeting, the Fed raised the fed funds rate by another 75 basis points to 4.0%.
The Fed is rightly concerned that inflation has become “stickier”, making its job much more difficult and requiring a far more restrictive policy with much higher interest rates than it initially believed.
The Atlanta Fed’s CPI measures the stickiness of inflation, separating CPI items into two baskets, “sticky” and “flexible”. The sticky basket contains items whose prices change less often, while the flexible basket contains items whose prices change quickly.
Roughly 70% of headline CPI items fall into the Atlanta Fed’s sticky price basket. The remaining 30% of items fall into the flexible basket. The sticky basket, represented by the black line on Chart 4, is highly correlated to Core CPI (i.e., less food and energy), which is represented by the green line, while the flexible items correlate with the non-core portion of the CPI.
Chart 4 highlights just how pronounced the stickiness of inflation is at the present:
- While notoriously volatile, for the past 12-to-18 months, both the 1-month annualized (blue dotted line) and 3-month annualized (yellow dotted line) sticky consumer price indexes have consistently been running higher than both the 12-month sticky CPI (black line) and Core CPI (green Line).
- With the sticky inflation figures still elevated, it’s likely that Core CPI will continue to remain stubbornly high. This is concerning for the Fed and why it has become much more aggressive in its public comments regarding inflation.
We believe the Fed’s biggest concern is that consumer inflation expectations become unanchored, indicating that the public has lost confidence in the Fed’s ability to control inflation.
Chart 5 shows the University of Michigan’s next 5-to-10-year inflation expectation survey (blue line), which is an important measure for the Fed. Keeping this measure anchored is of key importance. While the inflation expectations survey has come off its recent highs, the longer that inflation remains sticky, the likelier it is for inflation expectations to rise.
As you might imagine, new and used vehicles show up in the Atlanta Fed’s flexible inflation basket since vehicle prices aren’t particularly sticky. Used vehicle prices decline on average about 15% per year and have been a source of deflationary pressure on CPI, although only having a tiny deflationary impact given used vehicles make up a small percentage of overall CPI.
However, over the past two-years, lockdowns, supply chain shortages, and production issues for new vehicles drove used vehicle prices up about 45% (top of Chart 6). A move this size has certainly added to overall inflation, as well as near-term inflation expectations, despite the category’s small weighting to overall CPI.
In the lower part of Chart 6, we see used vehicle prices receding, with wholesale used vehicle prices down 10.6% year-over-year. However, they will still need to decline another 30% to get back to the trend. This will certainly reduce the flexible level of inflation and modestly reduce overall CPI, though it does not directly impact Core CPI.
Many consumers, though, will feel a big impact. There are roughly 40 million used cars sold in the U.S. annually, and most are financed. As used car prices move back down to normal levels, used car buyers will likely find their vehicle values declining at an accelerated rate, while still paying on loans based on elevated purchase prices.
This will create significant negative equity, resulting in trade-in values far less than what consumers owe on their auto loans. New car dealers will need to get creative through cheaper financing and dealer rebates if they want to sell new cars to the recent used car buyers. Importantly, the declining car values and declining home values have the potential to shrink consumer wallets and, along with it, consumer spending and consumer inflation expectations.
To tame inflation, history tells us the fed funds rate must move above the inflation rate. History also tells us that whenever the fed funds rate moves above the 10-year Treasury bond yield, a recession soon follows.
Today, the fed funds rate remains well below inflation (4.0% versus Core CPI of 6.3%). However, a few more interest rate hikes will bring us close to the point where the Fed will likely pause. Let’s hope the Fed does so before causing a deep recession.
That said, there are a lot of cross currents for the Fed to contend with. First, one of the biggest sources of inflation includes supply constraints for food, energy, metals, semi-conductors, and labor, which the Fed has little-to-no direct control over. A recession would only make supply constraints worse. These structural shortages require substantial multi-year investments, which are not likely to happen in a deep recession.
Further, after decades of expanding globalization, the recent de-globalization of trade between the democracies and autocracies has led to the reshoring of manufacturing and reorganization of global supply chains. The localization of manufacturing will require increased capital spending while increasing the demand for labor. Although good for the U.S. economy, it is also likely to keep upward pressure on inflation.
By lifting interest rates high enough, the Fed can kill demand and slow the economy. However, slowing inflation to its 2% target over the next couple of years would likely require a substantial increase in unemployment and cause a deep recession. This is not an outcome the Fed really wants as it would force a re-stimulation to the economy creating yet a bigger inflationary problem. As we have said repeatedly, we believe the Fed is in a box!
It’s yet to be determined just how high the Fed is willing to raise the fed funds rate, and though cyclical inflation will recede, we believe core inflation will prove to be more persistent than the Fed and most investors believe. It’s our view that the likely path forward is for core inflation to remain in a 3.5% to 5.5% range for the next several years with Treasuries at similar levels. As the impact of higher interest rates cycle through the economy, we expect continued rate volatility and with it the opportunity to extend duration in longer-dated Treasury bonds and high-quality corporate bonds at yields we haven’t seen in quite a long time.
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