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The Inflation Dam Will Not Break

Douglas Adams profile picture
Douglas Adams


  • Treasury yields are on the rise, with long-term levels approaching levels the CBO currently projects won't happen until 2024.
  • Rising yields and the fear of inflation were behind the pummeling of the Nasdaq last week, handing the Composite its biggest percentage loss since last October.
  • Will sustained inflation be the result as Covid vaccine supplies gain the upper hand in our quest for herd immunity and we gain some semblance of pre-pandemic economic normalcy?
  • The answer is no, and here is why.

Friday’s market close saw the Nasdaq plunge 6.41% from its most recent record close of 14,095 posted on the 12th of February. For the week, the Nasdaq fell a whopping 4.9%, its biggest percentage loss since the week ending 29 October. Stalwart growth positions like Amazon (AMZN), Tesla (TSLA) and Apple (AAPL) that sent the Composite to new heights during the year now bleed red as trading closed in February.

Without question, monetary and fiscal policy initiatives drove stock market to new heights during one of the most tumultuous years this side of the Great Depression. In addition to cutting the federal funds rate to near zero, the Federal Reserve’s balance sheet ballooned to $7.64 trillion through the end of February, up from the distant mid-March total of $4.36 trillion - levels not seen since WWII. On the fiscal side, the CARES Act that passed Congress in March pumped $2.2 trillion directly into the economy. A second round of direct payments to US citizens, about $900 billion in total, cleared Congress in December. And with the change of administrations, a third $1.9 trillion deposit on Covid-19 relief passed the House of Representatives over the weekend - this time on a largely partisan vote. The sum is sure to be reduced in an evenly divided Senate.

Is inflation dam about to break?

The Evidence

The bond market thinks inflation is nigh. Unsurprisingly, the monetary and fiscal responses to date have ignited a protracted, month-long selloff in the bond market. On the long-end of the yield curve, the 10-year Treasury note that started the year at 0.917% closed at 1.415% on Friday - up over 34% for the month and over 54% YTD. The yield on the 30-year Treasury bond forged a similar, though less spectacular path - up almost 16% in February and over 30% YTD. The yield on the 3-year Treasury note is up 73% while the 5-year Treasury

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

Analyst’s Disclosure: I am/we are long AAPL, TSLA, AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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Comments (12)

FredFrog profile picture
It seems to me that you are relying too much on the Fed's and CBO's inflation models. A couple of real world examples.
-- We went through McDonald's the other day and picked up two fish sandwiches, one chicken sandwich, and one small fry. Cost was $18 and change. A couple of months ago it would have been half that. And, BTW, the chicken sandwich was so bad it ended up in the trash.
-- Relocated six months ago and have been trying to buy a house. There are two problems: extremely low inventory and an excess of buyers. Houses are selling for 10-15% above fair value. Fair value being indicated by recent sales of similar houses (including the one next door). When there are two to three dozen buyers bidding against each other for the same thing and extremely low inventory you get absurd results.

I understand that housing and food don't rank high in the official inflation model. But for people living in the real world, housing and food are real costs and such rapid rises are actually inflationary.

Aside from my personal problems, there is the issue of how the governments of the world are going to pay off all of that debt they have been accumulating of late. Inflation looks like the best alternative; much more likely than default. Two percent will not be enough to significantly move the needle.

As a caveat, I suspect that bond yields will continue to subside in the near term. I just don't see them staying there for years; higher yields will return. When money is pulled out of the stock market and out of the bond market simultaneously it won't take long for it to return. Cash is not generally a good investment; unless you are expecting a very big drop in prices.
I dont see a coherent argument against inflation in this article. Maybe that high unemployment and persistent low wages will prevent it? My base case is huge inflation but only in certain sectors, although broad inflation possible because of higher energy, commodity, and semiconductor prices
Douglas Adams profile picture
@Miwicz Thanks for your comment.

The article addresses the concerns of the bond market regarding forward inflation. Accordingly, market-based measures of inflation come front and center. What do 30-year, 10-year, 7-year and five-year Treasury notes and bonds and their TIP equivalents tell us about inflation at each of these points on the yield curve?

A steepening yield curve historically portends faster growth which could ignite price inflation in the greater economy. Moving into a post-pandemic environment could ignite inflation given pent-up demand and an outsized savings rate. Fiscal policy disbursements during the pandemic have contributed to the savings rate to a certain degree as helicopter money implies everyone gets relief checks--whether they need it or not.

What I tried to argue is market based measures of inflation remain quite anchored, particularly at the short end of the yield curve. Real interest rates remain almost universally negative. The CBO projects the 10-year yield at 1.60% in 2024. Thursday's market close had the 10-year yield at 1.525%, which I called unsustainable in the current environment. The Federal Reserve continues to buy $120 billion of Treasuries and MBS each month to keep liquidity levels sufficient to bring GDP back to its full potential. The CBO projects that potential to be regained by 2024. In the meantime, there is little chance the Fed will raise the federal funds rate this year or next, implying inflation is not on the horizon. Headline PCE as well as core PCE measures have consistently come under the Fed's 2% target since the target was placed into service in 2012.

Outside of being starved for yield, fix income investors were clearly worried about increased government spending. Biden's $1.9 trillion pandemic relief program on top of the $2.2 trillion CARES Act and December's $900 billion, arguably, continues to be a primary factor in the steepening yield curve. Now with the $15/hour minimum wage portion of the bill being excised by the Senate Parliamentarian under reconciliation rules, the yield on the 10-year Treasury note has dropped 10 basis points in two trading sessions. The Nasdaq soared over 3% at today's market close.

Inflation appears not to be the overriding issue after all.
@Douglas Adams Thanks for the detailed response. The crux of your third paragraph above, as I see it, is that the market and Fed are not reacting as if inflation is coming (rates are low, Fed buying continues) and that PCE isn't rising yet. But the problem , regardless of how the market and Fed are currently reacting, is that (1) PCE isn't capturing existing inflation in certain sectors, such as housing and some other assets, energy, and certain commodities, and (2) the pent-up demand hasn't yet been unleashed so the a lot of the inflation potential is still there even if it will take 6 months or 1 year to materialize.

I think it's possible that, as with previous QE, the extra printed dollars never make into the broad money supply because of unemployment and depressed wages. But since the QE in 2020 was more broad based than in 2008 (all corps got free money, not focused on banks) and there's more direct stimulus, it seems likely that the broad money supply increased enough to cause inflation. On the flip side, I'm not sure that energy and commodity prices will continue to increase because broader supply and demand factors might counterbalance the extra money floating around.
Douglas Adams profile picture
@Miwicz The inflation capture of headline PCE in housing is about half that of headline CPI and is one of the reasons the Fed uses PCE rather than CPI in its projections of inflation. The S&P Case-Shiller 20-City Housing index is running 10.10% over the past twelve month period. Housing prices across the 20 MSAs continue to be a function of availability as the monthly supply in most areas remain extremely tight. NAR's monthly supply of existing homes for sale is down to 2.1 months, pushing prices to the upside.

Oil and feedstock deliveries to U.S. refineries declined 2.7 million b/d (17.5%) to 12.6 million b/d for the week ending February 19, 2021. While cold weather in the Gulf Coast refineries were a factor, the pandemic, remote working and the continuing debate on the future of the office keeps the lid on energy usage, despite rising prices in world markets from OPEC supply manipulations. As for other commodities, these are all priced in dollars, which continues to strengthen in world currency markets.

And if treasury yields continue to rise, we will start seeing major inflows to Treasury securities from world pension funds and other institutional fix income investors. The Japanese 10-year yield is around 0.13% while in Germany the 10-year yield is negative at -0.35% with today's market close. No rocket science needed here.

The extent of the pent-up demand from households in the greater economy as vaccines become more readily available continues to be the known unknown. Most economists still see a temporary boost in prices with little lasting impact, including the Federal Reserve. We'll see.

Reserves held at the Fed will likely rise with the return of the $500 billion or so on Treasury balance sheets from the pandemic. That is to happen by the end of March, depressing prices which in turn will pressure yields to the upside. I'm sure there are contingency plans on the shelf waiting to be dusted off and put into play.
bluescorpion0 profile picture
"Importantly, the cost of servicing that debt is significantly lower today than it was in 2007 because real interest rates remain almost universally negative."

So savers who worked a lifetime are being forced to lend to the government because it is bankrupt and cannot afford to pay a decent rate of interest. Is this fair? is it sustainable? is this kind of inter-generational theft/cheating something that happens throughout human history , the old die out and the young as a society just take their money?
@scorpion.north Banks lend out money being "held" in accounts. It has been that way since the first bank poofed into existence.
@scorpion.north It’s called EQUITY and current administration wants everyone (except them) on equal footing. Even if it means cutting others off at the knees. As a former DEM I can’t stand their direction and REPs lost my interest with Bush Jr. So I don’t see things getting better, just kicking cans down the road and blaming the other party when they both need to be held accountable. Next recession will be worse than March dip in 2020 and last longer. Unless we print even more money which we will because nothing better than kicking cans down a road while whistling Dixie
Douglas Adams profile picture
@scorpion.north Thanks for your comment.
No question fixed income investors, from households to insurance companies, are being penalized. The average yield on the 10-year Treasury note in 2007 was 4.63%. The CBO projects that same yield in 2020 at 0.9%. Real yields are largely negative given the rate of inflation. They will continue to be negative for the foreseeable future.

Yet low yields and copious liquidity from the Federal Reserve have also powered equities to outsized heights in recent years. Last year's returns for almost any equity-based portfolio was in double digits--even for the most risk adverse of investor.

Markets do provide alternative paths to wealth.
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