The Federal Reserve has become the focal point for the market as inflation, Fed asset purchases, and the timing of future interest rate increases dominate the current narrative.
The Fed finally began to talk about tapering its $120 billion monthly asset purchases of Treasury Bonds ($80 billion) and Mortgage-Backed Securities ($40 billion) since the economy and inflation are stronger than initially projected.
The Fed will not take any actions that puts at risk the current economic expansion but tapering its Mortgage-Backed Securities makes sense since the housing market has been robust and does not need the Fed’s help at this point.
The Fed’s actions may extend the current economic expansion.
The Latest Federal Reserve Meeting
At its last meeting, the Federal Reserve’s Federal Open Market Committee made its most significant hawkish shift yet, accelerating its timeline for hiking the Federal Funds rate to 2023 from 2024 and setting the table to end asset repurchases as soon as this year.
The Central Bank left little doubt that the government’s monetary and fiscal stimulus has reinvigorated economic activity. The central bankers believe the gross domestic product, or GDP, will grow 7% this year, up from its 6.5% forecast in March, resulting in core inflation of 3%, up from its prior outlook of 2.2%.
Gross Domestic Product
Source: US Bureau of Economic Analysis
Historically, the Federal Reserve has a reputation for underestimating inflationary pressure, forcing it to act more quickly and aggressively than originally planned. But you may remember that the Fed announced at its Jackson Hole meeting last summer that it was “willing to see inflation above their 2% target for a considerable period” before acting to reverse its course. Their reasoning for this position is that due to the extended period of years where we experienced inflation well below the Fed’s 2% target, we need a period of higher inflation to recalibrate the market’s expectation for future growth in price levels.
Personal Consumption Expenditures Excluding Food and Energy (PCE)
Source: U.S. Bureau of Economic Analysis
Whether this means the Fed is behind the inflationary curve now is anyone’s guess, but if it is, then we may see an even more hawkish tone over the coming year.
The Fed’s Dual Mandate
But the Fed’s stated intentions are to see continued progress in returning to full employment and reaching that objective will be the primary determinant of the timing of interest rate hikes by their reckoning. Of course, it is easy to commit to tolerating higher inflation when it does not exist (last summer the CPI reading was 1.2%). Still, it is something else to ask the Fed Governors, steeped in a tradition of fighting inflation, to stand by idly when prices are rising at their fastest pace since the 1970s. Already there seems to be some nervousness among a few Fed Governors about sticking to their “higher for longer” pledge on inflation.
For now, the Federal Reserve’s stance has sparked a tug-of-war between those arguing rate hikes are too far off in the future to worry of a slowdown and those believing the Fed’s timeline is still too optimistic.
Confusing Signals from the Bond Market
With the CPI forecast to hit close to 4% later this year, that does not sit well with a bond market trading 10-year Treasury bonds with a 1.5% yield. Even if inflation moderates, as the Fed and the market predict, the market expects it to average almost 2.5% over the next five years. Bond investors will not stand idly by and continue to accept a negative real yield of close to 100 basis points (2.5% inflation minus 1.5% Treasury Yield equals a 1% negative real yield).
We believe that the 10-year Treasury is heading towards 2% in the coming months, which will cause some anxious moments for the stock market, like the rise in the Treasury rates during the 1Q21 that hit the market hard.
10-Year Treasury Bond Yield
Source: Board of Governors of the U.S. Federal Reserve
Here is a small list of factors that should be causing higher yields on Treasury bonds:
- Massive fiscal and monetary stimulus,
- Double-digit economic growth,
- Widespread wage increases,
- The prospect of massive infrastructure spending, and
- Future reopening gains as vaccinations continue to spread worldwide.
At some point, bond investors will not be satisfied investing in a bond with a negative real yield. Rates must rise to make this a more economical investment.
Another Point of View on Rates
Another point of view is that bond investors are forecasting a significant slowdown in the economic expansion later this year due to high inflation, geopolitical tensions, and COVID variants ramping quickly, which would cause inflation to drop along with valuations in the equity markets.
Additionally, bond investors may believe that we are experiencing a high-water mark for GDP growth, corporate earnings, and accommodative monetary and fiscal policy. The receding waters in the quarters to come will be swift and turbulent, they figure.
We do not share this view, but it is the narrative discussed to justify today’s low-interest rates.
Concerning future earnings growth, new auto and home sales did stagnate last month, but that has more to do with supply chain (microchips) issues in the automotive business and affordability. An uptick in mortgage rates and increasing affordability issues are taking hold in the housing industry. The former will return to sales growth as the supply chain issues abate, and the latter is a necessary respite for a housing industry heading towards a pricing bubble.
Finally, we are less worried about the CPI getting out of control as we believe an increase in productivity caused, in part, by higher capital expenditures by corporations and $1.2 trillion in infrastructure spending by the government will offset most of the wage gains, which is, after all, 66% of the CPI. Additionally, the inflationary pressures from the U.S. conflict with more deflationary impacts globally. There is still a lot of slack in the lands outside our borders which acts to keep a cap on price increases generally.
The economy is strengthening, and inflation is accelerating due to supply shortages as production has not caught up with final demand. Over half of the increase is transitory, but it may take a year for these problems to abate. As a result, inflation will persistent into 2022, but the rate will fall as we progress further into the year.
The Fed does not want to do anything that will slow this economy and getting unemployment back to its pre-pandemic lows remains the primary objective of the Federal Reserve and Congress.
We remain confident in investing in the economically sensitive areas such as the consumer discretionary and technology sectors, where we expect companies to report surprisingly strong earnings, profit margins, cash flow, dividends, buybacks, and return on invested capital. Additionally, the prospect of higher mid-to-long term interest rates with short rates anchored to the seafloor by Fed policy bodes well for banks who borrow short and lend long. Additionally, with all the 23 “systematically important financial institutions” (SIFI), government-speak for big banks, passing the Federal Reserve stress tests suggests that hefty dividend hikes (disallowed until now) and stock buybacks (ditto) lie ahead.
Finally, with inflation running high and economic growth peaking in the next quarter, investors need to look deeper into company businesses to find out which firms can succeed in a more challenging economic environment. We focus on profit margins and economic profitability to identify firms with pricing power. These types of companies can raise prices as their costs increase to limit the damage wrought by inflationary forces.
John P. Swift, CFA®, CPA
Chief Investment Officer