The Inflation Dam Will Not Break

Summary

• 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 12^th 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 note soared 109% YTD. Meanwhile on the short-end of the yield curve, the one-month and three-month Treasury bills have dropped 33% and 49%, respectively, while the yield on the 2-year Treasury note has barely budged over the period, down a mere 3.2% through Friday’s market close.

A steepening yield curve has historically signaled faster economic growth. While the National Bureau of Economic Research (NBER) drew the curtain on the longest expansion of the post-WWII period and the beginning of a pandemic-induced recessionary period in mid-February, it has not yet declared the endpoint of the Covid recession. Congressional Budgetary Office projections have the downturn ending in the 2^nd quarter. GDP fell 31.4% in the 2^nd quarter, rebounding 33.4% in the 3^rd quarter and finishing out the year with a 4.1% GDP spurt in the 4^th quarter. At the same time, and with copious help from the Federal Reserve, the S&P 500 soared over 63% after scratching bottom on the 23^rd of March.

Many economists do expect an upside trajectory on Treasury yields through the rest of the year due to a variety of outstanding factors. Included in the mix is an increasing supply of Covid-19 vaccines and inoculations as herd immunity comes closer to realization. The so-called reflation trade is a broad signal that the economy will rebound quickly and restore some semblance of pre-pandemic economic normality. Rising confidence could spark higher price inflation in the greater economy. Higher fiscal spending also tends to push bond prices down and yields up by boosting economic growth and with it - price inflation. Higher levels of inflation migrating through the greater economy makes fixed income investments unattractive.

Further pressure on yields come from a recent Treasury decision to reduce its balance sheet cash to around $500 billion from levels that exceeded $1.6 trillion in the heat of the pandemic. The move will flood the market with excess liquidity in the latter part of March, sending yields at the short end of the yield curve further into negative territory while possibly wreaking havoc on the money market space. Banks, meanwhile, may be forced to hold unwanted crates of cash at the Fed which could be more than $5 trillion by early summer.

And on the receiving end, household savings totaled $3.9 trillion in January, up from $1.4 trillion last February. Spending rose 2.4% MOM while personal income shot up 10% in January MOM, mostly a result of fiscal stimulus checks. Disposable income rose 11.4%. Headline PCE, the Fed’s preferred measure of inflation, remained quiescent at 1.5% YOY. Savings were up over 20% during the month from 13.4% in December, pushing the month’s savings to the highest level since May and the highest total since WWII. Expenditures on services, about 70% of the economy, dropped 5.4% YOY.

The Reality

In dollar terms, real GDP in the greater economy came to $18.8 trillion in the 4^th quarter, about 6% below potential, according to CBO projections. The resulting output gap comes to $1.1 trillion, in rough alignment with the Biden administration’s $1.9 trillion package. With more than 75% of the package in the form of direct payments to households, unemployment benefits to furloughed workers and other income support, the fiscal intervention will more likely than bring immediate, though short-term, relief from pandemic-induced disruptions to household balance sheets with minimal multiplier impact to prices in the greater economy. The short-term nature of the latest fiscal intervention is key to keeping inflationary pressures on the intermediate- and long-end of the yield curve at bay.

Another important caveat is the aid package’s reconciliation path to approval by Congress. The reconciliation process has already axed the $15/hour minimum wage proposal passed by the House but excised late last week by the Senate Parliamentarian, leaving progressives scrambling to find a different avenue to raise the federal minimum wage. Friday saw the month-long yield charge lose steam with the 10-year note falling to 1.432% from Thursday’s 1.552% for the first such decline of the month. The breakeven inflation rate, which moves in the opposite direction, rose to -0.71% from Thursday’s -0.60% on the news. More downward movement in yields on the longer-end of the yield curve with upward moves in BE rates could be in the offing as the legislation wends an uncertain path through the Senate.

Breakeven rates do, however, remain curious as shorter BE rates are now higher than longer BE rates. The 10-year BE rate is 2.14% through the end of February, up from 1.54% at the beginning of the year. The real interest rate at the 10-year level, however, remains negative 0.71%. The 30-year BE rate is 2.10% through the end of January, up from 1.79% YOY with the real interest rate just turning positive at 0.03% on the 19^th of February for the first time since June. Friday’s market close saw the 30-year BE close at 0.06%. The curiosity comes with the 5-year BE reaching 2.39% - the note’s highest post since April 2011. The real interest rate of the 5-year note, however, remains solidly negative at -1.64%.

Breakeven rates could also influence inflation expectations as TIP yields have risen in February as BE rates have fallen. February’s snapshot could signal weaker growth and a higher likelihood that the Fed will intervene with an uptick of the federal funds rate - or both scenarios simultaneously. Weaker growth in the greater economy and Fed intervention are both highly unlikely. The Fed fund futures project a 4.1% chance of an increase in the funds rate at the forthcoming April, June, September, November and December meetings. At the same time, pandemic lockdowns, stay-at-home mandates, savings rates have all kicked pent-up demand into high gear.

A final note on the deficit. For the first four months of FY2021, the federal budget deficit rose 90% to $738 billion, driven by $142 billion in direct payments to households, $25 billion in rental assistance grants to state and local governments and $34 billion in unemployment benefits. At the beginning of the Great Recession, debt-to-GDP stood at 35%. Fast forward a number of years, the ratio is more than 100%. Importantly, the cost of servicing that debt is significantly lower today than it was in 2007 because real interest rates remain almost universally negative. Interest as a percentage of GDP is under 2%. That gives public policy a good deal of room to maneuver to get the greater economy back on track and people back to work - quickly.

Postscript

Current projections on personal consumption expenditures (PCE), the preferred measure of the Federal Reserve, projects out at 0.4% in 2020 to 2%, the Fed’s long-term inflation target, by 2024. CBO projections have the yield on the 10-year Treasury note gradually rising to the upside from an average of 0.9% in 2020 to about 1.6% by 2024. Thursday’s yield on the 10-year note hit 1.552% appears unsustainable. Inflation remains firmly anchored for the foreseeable future.

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.

Comments

[FredFrog]

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.

[Miwicz]

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]

@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.

[Miwicz]

@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]

@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]

"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?

[User 51752784]

@scorpion.north Banks lend out money being "held" in accounts. It has been that way since the first bank poofed into existence.

[GNR8NRG]

@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]

@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.