The Inflation Fiddler Is Climbing To The Roof, Dragging Yields With It

Summary

• For many decades, there was a long-standing, traditional, link between the economy and monetary policy. That link got broken in 2008, and it hasn't fully recovered ever since.
• We've already got used to living with stocks that are trading way ahead of the economy, but can we live with yields that are trading way behind the economy?
• It seems as if the Fed's Powell has made his mind, keeping the official monetary policy intact, while allowing/hoping for yields to do the "dirty job" for him.
• Higher growth rate, higher inflation, higher yields, even a rate hike on the horizon. The macro landscape is changing fast, and we must adjust rapidly.
• I do much more than just articles at Wheel of Fortune: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

Untraditional Inflation

This article is written during the morning of March 17.

In a few hours, the FOMC will conclude another meeting, and everybody is waiting anxiously to see whether the Fed officials would keep their chairman recent stance, i.e. sounding relaxed about a higher inflation, consequently allowing US Treasury yields to rise further.

This is quite a diversion from Powell's traditional dovish comments, signaling that while an official monetary policy tightening (rate hikes, pause on bond buying) isn't on the horizon, an indirect tightening, through the market (allowing yields to rise) isn't only an option, but a welcome outcome.

After all, the Fed is seeing what everybody else does: An economy that's overheating, thanks to both vaccination/reopening on one hand and fiscal stimulus on the other hand.

Just like the "Pied Piper of Hamelin" story goes, when Powell plays his violin, investors follow his tunes.

Traditionally, such an overheating would call for an action, and Powell likely needs to hold himself in order not to spook the market with too direct-blunt remarks. After all, the last thing he wants is to be the one ruining the party.

Nevertheless, down deep even Powell knows that if he's doing nothing now - he might need to do too much later. Therefore, the easiest solution for him is to employ a "good cap, bad cap" strategy:

• Maintain a firm commitment for monetary policy to remain loosened, for an extended period, on one hand.
• Welcoming a higher inflation and encouraging bond yields to rise, de-facto causing financial conditions to tighten, on the other hand.

Tradition. Without our traditions, our lives would be as shaky as... as a fiddler on the roof!

Source: Fiddler on the roof - Tradition

Try to listen to the song while making a few little tweaks to the lyrics:

• Instead of "tradition" - think/hear "inflation"
• Instead of "The Papa" - think/hear "The Powell"
• Instead of "The Mama" - think/hear "The Janet"

If you make a genuine effort to replace some of the original key words, as suggested, you might even hear Tevye saying at the end the song:

Inflation. With our inflation, our lives would be as shaky as... as a fiddler on the roof!

(Source: Author)

To Be or Not to Be?

The official data is still showing no signs of an upcoming storm.

February CPI came in at 1.7% Y/Y, higher than the 1.4% Y/Y last month but in-line with expectations.

Core inflation came in at only 1.3%, higher than the 1.4% Y/Y last month and slightly below expectations for the same reading this month.

Of course, since the coming months of March-April are going to be measured against the very weak/extraordinary March-April of 2020 (when the market collapsed, the pandemic broke, and lockdowns were imposed), we're going to see higher inflation rates soon.

However, the key question is what's going to happen after the next 2-3 months?

Are we going to witness a short-lived spike in inflation, or is this only a loud introduction for something more fundamental and persistent (even if less loud) down the road?

Will inflation spike way higher than the Fed's 2% target or are all these talks about 3%, even 4%, much ado about nothing?

On one hand, you have Bill Gross, aka "Bond King," who's said that he's expecting not only higher yields (shorting UST10Y), but also a higher inflation that could reach 3%-4% in the near-term.

On the other hand, you have Guggenheim Investments that writes:

Incoming data support our view that underlying inflation is slowing, not accelerating....We believe that the balance of risks is skewed toward lower bond yields.

Here's how Chetan Ahya, Morgan Stanley's Chief Economist and Global Head of Economics, starts a recent article (emphases ours):

A comeback in inflation is no less likely because it has been absent for the past 30 years.

On the contrary, the conditions are ripe for US inflation to overshoot 2 percent, the level that the US Federal Reserve gauges as consistent with its mandate. Under its new approach unveiled last year, the Fed has signalled it will tolerate an overshoot of the target for a period of time to compensate for persistently low inflation.

The risk, as I see it, is that inflation could overshoot the overshoot levels the Fed is comfortable with.

Source: Financial Times

Even in the Fed's website itself, under the FAQs, you can find the following answer to a question titled "Why does the Federal Reserve aim for inflation of 2 percent over the longer run?" (emphasis ours):

Following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation modestly above 2 percent for some time.

The key words are obviously "modestly" and "some time".

• What exactly is "modestly?" - 2.5%?... 3%?... more than that?...
• How long is "some time"? - weeks?... months?... perhaps a year?

Inflation Expectations are Out of the Gate

Inflation expectations are everywhere.

United States

Inflation expectations for the next 5 years are at the highest level since 2008, nearly twice as high as where core CPI is.

Even more alarming, or convincing if you'd like, than market breakeven rates, is recent economic data, clearly pointing out at a higher inflation:

• Based on where Services PMI prices are, core CPI deserves to be at 3%.

• Based on ISM Manufacturing prices, headline CPI deserves to be at 4.7%.

• Based on the expected Y/Y change in oil price*, headline CPI should be ~4%

*Ignoring the 300% Y/Y jump we're about to be at, when oil price would be compared to the -$37 it traded at a year ago. Otherwise, based on that Y/Y change, the implied CPI would be ~14%...

• Based on NFIB prices, core CPI deserves to be at 3% (in a few months)

Speaking of NFIB, the Small Business Optimism Index is showing strength in selling prices (while line) and particularly hiring plans (blue line), with the latter at the highest level since 2008.

Many claim that the nearly 0.3% difference between inflation expectations for the next five years to the subsequent five years is a proof that higher inflation isn't on a sustainable path.

However, we have to remember a couple of things:

1) Five years is a long period as is

2) An inverted inflation expectations curve isn't common. Something got to give, and it's not necessarily going to be the next 5 years.

3) More stimulus is upon us, and a few more trillions are likely to be injected into an already overheated economy.

4) GDP expected growth is out of the roof.

Morgan Stanley has recently raised its US 2021 growth forecast to 7.3%, and that's still below Goldman Sachs' 8%...

Either way, we're looking at GDP growing at an annual rate we haven't seen since the economic boom that followed the 1951 Korean war.

With growth at 7.3%-8% and UST10Y at (only) 1.6% - the gap between these two gauges hasn't been as wide as it's now in 55 years! (and counting)

Europe

If you think that things are only heating up at one side of the Atlantic ocean - think again.

Of course, Europe is Europe, with a slower pace and magnitude, meaning that what you see in the US is happening on a smaller scale in Europe.

Nonetheless, when inflation expectations in Europe are at a two-year high - this also is something to celebrate.

Since the ECB made it clear that it remains fully committed to its bond buying program, and even intends to speed-up its Pandemic Emergency Purchase Program ("PEPP") program (to tackle the recent bond selloff) - there's no reason to expect less liquidity anytime soon; quite the contrary.

Of course, while in the US, Fed Chairman Powell is pushing yields higher, ECB President Lagarde is doing the opposite.

The reason is simple: Europe might be heating up, but it's far from being "overheated" as the US is.

The ECB PEPP has a total spending power of 1.85 trillion Euro and it was supposed to last for another year (until March 2022). Obviously, if they speed up the pace of spending, the program will run out of money sooner.

Therefore, it's likely to expect the ECB to increase the PEPP firing power soon, as early as in the next meeting.

Just like Powell, Lagarde is willing to allow inflation to spike, temporarily.

European CPI is still running at a <1% pace, and (as shown above) inflation expectations are only running at a ~1.5% rate.

This leaves the ECB plenty of room to keep printing money and supporting the economy, which is expected to grow nowhere near the US 2021 expected growth.

As a matter of fact, in its most recent economic growth update, the OECD has revised the Euro area expected growth in 2021 down to 3.9%, compared to 4.7% in its December forecast (though hiked 2022 to 3.8% from 2.9% in return).

At the same time, the OECD increased its 2021 growth forecast both globally (to 5.6%), and for the US particularly (to 6.5%), showing how far behind Europe still is.

China

China, like China, is a different story.

While in the US, M2 money supply growth rate is skyrocketing, this isn't the case in China. So much so that Chinese M2 money supply growth rate isn't only trending down, but it's way lower than it was during the GFC of 2008.

Putting it differently, over the past year the US is reacting like China did back in 2008, while China is reacting more like the US did back in 2008.

As such, and although economic gauges in China point to healthy growth, there is no inflationary pressure in China.

If anything, there are deflationary pressures.

At the same time that oil prices are pointing to a higher inflation in the US (as shown above), they are pointing to very little inflation in China.

Musical, diverging, chairs.

Bottom Line

While we're focusing on inflation in this article, those are yields that we're mostly concerned about.

No matter how you turn things around, we believe that until the Fed puts a stop to it, as we've discussed last week, yields are poised to rise. Not only is the Fed unlikely to rush into imposing limits on yields (at current levels), when the economy is so hot, but we actually think that it's in the best interest of Powell to allow - and even push - for higher yields.

Higher yields are de-facto a monetary tool that allow the Fed to cool the US economy off, even if only a bit. When you can't (or don't want to) hike rates (Fed Funds), when you're still (officially) far from reaching full employment, and when you don't want to crash the stock market - this is the best way to try walking between the drops, while staying dry.

After all, the market cap of the MSCI All-Countries index is at a record-high against global GDP, implying that stocks have gone way too high, way too fast, compared to the real economy.

US debt is climbing like there's no (payment) tomorrow (or any other time in the future...).

If you like federal debt at 100% of GDP in 2020, you would love federal debt at 200% of GDP in 2050.

Indeed, none of us knows whether we will be around in 2050, but the unsustainable path of US debt is not only "known," but a certainty.

Looking at US aggregate debt (not only federal debt), we're way past the 200% threshold. As a matter of fact, the US is way closer to 300%, and please don't let the recent drop create a long-term illusion.

Indeed, if growth rate comes at 8% that would be fantastic news, but unfortunately not good enough to overrun the pace at which US debt runs at.

Even if the Fed is not yet at the point of "thinking about thinking" about a rate hike, the market has started its 'thinking' already, currently pricing in a rate hike as early as in January 2023 (and 4 hikes in total till early 20224).

Four decades ago, global financial markets and the world economy were more or less at the same size.

Today, the former is about four times bigger than the latter.

We strongly suggest to seriously take into consideration:

• Higher inflation, for longer than just a couple of months
• Higher yields, with UST10Y certainly capable of reaching 2%
• Higher allocation to inflationary/value assets on the expense of deflationary/growth assets

However, if you think that this only calls for a "stocks over bonds" preference - you might wish to hold your horses. Things are not as simple as that.

The ratings we assign to the 11 S&P / GICS sectors are very much in line with the above-mentioned considerations.

Don't get caught unprepared!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.