This is from an email that I received from my banker. He gets these from a company called TIB Capital Markets. This seems pretty spot on to me. We keep raising interest rates and no one is pulling back. I was at a restaurant (nothing special.) in Wimberly last night and the wait was 3 hours. (We didn't wait lol.) I feel like the fed keeps raising rates and people keep spending. People are starting to buy homes again. Is this a lul? a calm before a bigger storm? Thought's?
"The benchmark 10-year treasury yield has been creeping its way up this month from a low in the 3.30% range to this morning's 3.71%. During the same period, the 2-year treasury is up from 4.10% at the beginning of the month to this morning's 4.50%. The importance of choosing those two bonds is that the 2-year is a proxy for fed funds or short rates in general that are most impacted by Federal Reserve policy, and the 10-year yield reflects long-term inflation expectations.
Given the 10-year yield is so much lower than the 2-year, the market is signaling two things: A belief that long-term inflation is not a problem and that it is likely the FOMC will tighten rates to the point it pushes the economy into a recession and ultimately lower rates.
How infallible is this logic? Just last summer traders were betting the Federal Reserve would be cutting rates by now in the belief inflation would quickly subside and pave the way for the central bank to shift its focus to shoring up growth. Of course, this has not come to pass and indeed the FOMC orchestrated its eighth straight increase in the Fed's benchmark rate last on Feb. 1st. Traders were forced to capitulate on that notion months ago and have pushed back their predictions for a rate cut to September. In fact, currently fed funds futures contracts have priced in three 25 basis point cuts by Jan. 2024.
In my opinion, the market is wrong. They are looking at the current bout of inflation through the lens of the last 25 years of history. I hate to sound like an old codger but I don't think enough traders have been around long enough to realize the threat before us. I will admit both bond and stock markets naturally want to rally. It is just hard-wired into the system. It's how everyone makes money. However, there are structural changes that ensure base-line inflation will be elevated. As Neel Kashkari, president of the Minneapolis Fed and former investment banker and trader, said recently, "I've spent enough time around Wall Street to know they are culturally, institutionally, optimistic." He had a warning for investors: If they doubt the central bank's resolve to properly finish the job on inflation, even at the cost of putting millions of Americans out of work, they are mistaken. "They are going to lose the game of chicken, I can tell you that."
As I mentioned before, a key point about the latest rally: It's not helping the Fed at all in its effort to quell inflation and may paradoxically force the Fed to raise rates higher than they would have otherwise. Look to mortgage rates as an example, they are down approximately 1% from their high late last year, spurring increased home activity.
"The Fed is grappling with a market that doesn't believe them, and so I think you have to think of the Fed as performative," said Jason Brady, Thornburg Investment Management. In other words, expect more tough inflation-fighting rhetoric from Chairman Powell.
It is true that inflation has begun to abate. CPI came in at an annualized rate of 6.5% in December, down from a high of 9.1% last year. The problem is the market seems to project this decline all the way down to 2% and that is a mistake. All it takes is a simple look around the grocery store, the car dealer, dry cleaner, gas station, and all of our daily transactions to realize inflation is not getting better. I read an academic report yesterday that showed if the government calculated inflation today as they did in the 1980s, we would be at double-digit rates.
A paradigm shift has occurred and it seems to have escaped Wall Street. Ever since the late 1980's, traders had been taught that the Fed was always there to prop up financial markets when things got really dicey. It would scrap plans to hike rates or maybe even start cutting them. "The Fed put," they called it. It culminated in the zero-interest regime and astounding amounts of free money helicoptered into the economy. We now are realizing that was a mistake. It distorted capital allocation. It punished savers. It forced consumption. When money was abundant and free, investors assumed it would be there forever. It set the stage for the generational shift to higher inflation. It is a mistake to think we are going back to 2019 or 2020. Habits are hard to break but break they will. The Fed will assure it. They have no choice. They realize the most detrimental force to our economic health is inflation.
Jeffrey Gundlach, the very successful and smart chief investment officer at DoubleLine, tweeted recently that "There is no way the Fed is going to 5%. 40-plus years of experience in finance strongly recommends that investors should look at what the market says over what the Fed says." He is wrong on this one. Fed funds will go to 5%. I give it 50/50 odds they go to 5.25% or 5.50%. The market has thrown down the challenge to the Fed and the Fed is determined. (For the record, I don't do Twitter, I read about the tweet.)
I, for one, am going with the Fed on this one.
Now, if we get a major exogenous event, say for example, China invades Taiwan, then all bets are off. The pandemic was such an exogenous event that changed everything and there are no shortages of candidates for another.
Speaking of that cool word; exogenous, the markets are attributing all this inflation to the effects of the last exogenous event, the pandemic, and none are considering there are structural changes in the world economy that will cause baseline inflation to be higher. Markets think once the dust settles from all the monetary and supply-chain issues related to the pandemic, things (inflation) will return to where it was before. I don't buy it. There are very real and very serious structural changes to the world economy that will cause the economy to be less efficient, but more resilient, and base inflation to be higher.
Have you shopped for a vehicle lately? I suspect the manufacturers and dealers are rather liking the pricing power they enjoy and are in no hurry to see it change. Do you think the pressure on fossil fuels and energy costs will abate? How inflationary is higher energy cost?"
"The benchmark 10-year treasury yield has been creeping its way up this month from a low in the 3.30% range to this morning's 3.71%. During the same period, the 2-year treasury is up from 4.10% at the beginning of the month to this morning's 4.50%. The importance of choosing those two bonds is that the 2-year is a proxy for fed funds or short rates in general that are most impacted by Federal Reserve policy, and the 10-year yield reflects long-term inflation expectations.
Given the 10-year yield is so much lower than the 2-year, the market is signaling two things: A belief that long-term inflation is not a problem and that it is likely the FOMC will tighten rates to the point it pushes the economy into a recession and ultimately lower rates.
How infallible is this logic? Just last summer traders were betting the Federal Reserve would be cutting rates by now in the belief inflation would quickly subside and pave the way for the central bank to shift its focus to shoring up growth. Of course, this has not come to pass and indeed the FOMC orchestrated its eighth straight increase in the Fed's benchmark rate last on Feb. 1st. Traders were forced to capitulate on that notion months ago and have pushed back their predictions for a rate cut to September. In fact, currently fed funds futures contracts have priced in three 25 basis point cuts by Jan. 2024.
In my opinion, the market is wrong. They are looking at the current bout of inflation through the lens of the last 25 years of history. I hate to sound like an old codger but I don't think enough traders have been around long enough to realize the threat before us. I will admit both bond and stock markets naturally want to rally. It is just hard-wired into the system. It's how everyone makes money. However, there are structural changes that ensure base-line inflation will be elevated. As Neel Kashkari, president of the Minneapolis Fed and former investment banker and trader, said recently, "I've spent enough time around Wall Street to know they are culturally, institutionally, optimistic." He had a warning for investors: If they doubt the central bank's resolve to properly finish the job on inflation, even at the cost of putting millions of Americans out of work, they are mistaken. "They are going to lose the game of chicken, I can tell you that."
As I mentioned before, a key point about the latest rally: It's not helping the Fed at all in its effort to quell inflation and may paradoxically force the Fed to raise rates higher than they would have otherwise. Look to mortgage rates as an example, they are down approximately 1% from their high late last year, spurring increased home activity.
"The Fed is grappling with a market that doesn't believe them, and so I think you have to think of the Fed as performative," said Jason Brady, Thornburg Investment Management. In other words, expect more tough inflation-fighting rhetoric from Chairman Powell.
It is true that inflation has begun to abate. CPI came in at an annualized rate of 6.5% in December, down from a high of 9.1% last year. The problem is the market seems to project this decline all the way down to 2% and that is a mistake. All it takes is a simple look around the grocery store, the car dealer, dry cleaner, gas station, and all of our daily transactions to realize inflation is not getting better. I read an academic report yesterday that showed if the government calculated inflation today as they did in the 1980s, we would be at double-digit rates.
A paradigm shift has occurred and it seems to have escaped Wall Street. Ever since the late 1980's, traders had been taught that the Fed was always there to prop up financial markets when things got really dicey. It would scrap plans to hike rates or maybe even start cutting them. "The Fed put," they called it. It culminated in the zero-interest regime and astounding amounts of free money helicoptered into the economy. We now are realizing that was a mistake. It distorted capital allocation. It punished savers. It forced consumption. When money was abundant and free, investors assumed it would be there forever. It set the stage for the generational shift to higher inflation. It is a mistake to think we are going back to 2019 or 2020. Habits are hard to break but break they will. The Fed will assure it. They have no choice. They realize the most detrimental force to our economic health is inflation.
Jeffrey Gundlach, the very successful and smart chief investment officer at DoubleLine, tweeted recently that "There is no way the Fed is going to 5%. 40-plus years of experience in finance strongly recommends that investors should look at what the market says over what the Fed says." He is wrong on this one. Fed funds will go to 5%. I give it 50/50 odds they go to 5.25% or 5.50%. The market has thrown down the challenge to the Fed and the Fed is determined. (For the record, I don't do Twitter, I read about the tweet.)
I, for one, am going with the Fed on this one.
Now, if we get a major exogenous event, say for example, China invades Taiwan, then all bets are off. The pandemic was such an exogenous event that changed everything and there are no shortages of candidates for another.
Speaking of that cool word; exogenous, the markets are attributing all this inflation to the effects of the last exogenous event, the pandemic, and none are considering there are structural changes in the world economy that will cause baseline inflation to be higher. Markets think once the dust settles from all the monetary and supply-chain issues related to the pandemic, things (inflation) will return to where it was before. I don't buy it. There are very real and very serious structural changes to the world economy that will cause the economy to be less efficient, but more resilient, and base inflation to be higher.
Have you shopped for a vehicle lately? I suspect the manufacturers and dealers are rather liking the pricing power they enjoy and are in no hurry to see it change. Do you think the pressure on fossil fuels and energy costs will abate? How inflationary is higher energy cost?"
