Treasury rates have ticked higher in recent weeks, due to investor worries about a pickup in inflation. This is not a new concern, but has gained steam as a large ($1.9 tril.) stimulus package appears to be on the verge of passage in Congress, as well as the economy showing signs of broader recovery otherwise, with help from prior stimulus.
Some of this concern has been fueled by comments from well-known economists, such as former Treasury Secretary Lawrence Summers, who warn about potentially negative side effects from the massive size and spending priorities of the stimulus. From a classical economic sense, inflation represents one risk from such a large cash outlay. The fact that he’s served under several Democratic administrations was especially noteworthy to markets.
The classic definition of inflation is too much money chasing too few goods. The notable economist Milton Friedman classified inflation as ‘always and everywhere a monetary phenomenon.’ On the consumer side, government stimulus money can end up in a variety of landing places, including the buying of goods and services (the main hope), being invested into asset markets, or saved as rainy-day funds. For those employed and able to work from home, one impact has been far stronger household balance sheets, from debt pay-downs and lack of opportunity to spend discretionary funds (like restaurants and entertainment). In addition, it seems some degree of social boredom, leading to the ‘gamification’ of financial markets (Gamestop saga), shouldn’t be underestimated. Already, the measure of ‘M2’ (cash plus checking plus savings/money market assets) is up 25% on a year-over-year basis. This is more than double the 10% year-over-year increase in 2009 during the financial crisis (where stimulus was more directed to the financial system). This is strong wave of money, some of which is going toward living and expenses and rent, while some isn’t.
On the other hand, the pandemic created a large economic dislocation, on the order of the financial crisis and 1930’s Great Depression. Such a drop widens the output gap—this is the difference between the actual level of GDP and ‘best case’ GDP if the economy were running at full potential. This gap can’t be measured well in real time, but the ‘hole’ from the decline must be repaired before normal trend growth can resume. This ‘backfilling’ of economic damage before moving on has been argued by economists to be far less inflationary, since this technically isn’t considered excess.
Realizing that inflation has been both feared and welcomed for several decades, despite staying under control, there are a few currently-debated scenarios. It’s also key to separate inflation into shorter-term rebound effects vs. longer-term secular effects.
- Rising inflation/rising rates. This could be caused by that build-up of spendable savings in the banking system, as well a release of pent-up demand generally. This can lead to rising asset prices, rising commodity prices, and possibly rising wages if it continues for long enough and becomes more entrenched in the economy. This is what occurred in the 1970s, accompanied by President Ford’s ‘WIN’ (Whip Inflation Now) buttons. This has taken place to some degree this time, as cash coupled with low interest rates have fueled portions of the stock and residential real estate markets.
o There are some fears of a weaker dollar as a corollary to this, as higher inflation in a country tends to weaken that currency’s future prospects versus other currencies. This has made the most sense in isolation, but in this case, European and Asian nations have provided sizable stimulus as well. It’s just as likely that a weaker dollar is due to a reflation of the broader global economy, which rewards more cyclical currencies, such as those in Europe and EM nations. This is simply the opposite of funds flowing to the U.S. dollar, which is often seen as a safe haven. This U.S. dollar currency weakness can be a benefit, as it encourages more attractive U.S. exports, as well as enhanced returns in unhedged foreign stock and bond investments for U.S. investors.
- Stable long-term inflation/continued low rates. Due to the unique event-driven nature of the pandemic, other economists argue that the output gap hole created is more severe than can be measured by usual metrics. Therefore, it may take longer to recover from. This could end up dampening recovery growth and keep inflation more contained than the worst-case scenarios. Aside from the Covid downturn and recovery, secular global demographic and productivity trends continue to point to lower growth than in past decades. As long-term inflation has been closely related to long-term growth, these slower trends could tend to keep inflation somewhat in check (at least lower the probabilities of ‘hyperinflation’), and have a downward effect on interest rates. Additionally, the advent of continued more productive technology and cheapening of many services (such as many things done online, Amazon effect, etc.) would serve as a downward force on prices as opposed to an upward one. In recent decades, the transition of jobs from the goods-producing to less capital intensive services sector, as well as the weakening of labor unions, has held down the power of workers to demand wage increases.
In short, economists disagree about the presence or absence of inflation pressures. But even in a more severe case, the probability of ‘hyperinflation’ (like that seen in the 1970s) appears to be an out-of-mainstream view. It’s also important to decompose inflation into its respective parts. While higher food prices added to trailing 12-month inflation, energy prices have dampened it. On the core inflation side, shelter costs have been boosted by strong housing prices, continued higher inflation rates in medical care services, as well as one-off pandemic events like a scarcity of used cars. Inputs such as copper and lumber are also more expensive, although these are less captured in broader inflation indexes. On the other hand, prices for apparel and general recreation have barely budged over two decades, while technology and communications inputs have been deflationary.
Even if actual trailing inflation remains in check, rising inflation expectations can create pressure on the economy and financial assets. This is the crux of what’s happened in recent weeks. Higher rates negatively affect bond prices directly, but also equities, as interest rates represent a key input into valuation models of future cash flows. When rates rise, the present value of these future flows falls, and lowers overall equity fair values—causing current prices to appear more expensive by comparison. This is an important input for all assets that have cash flows, and explains why financial assets are so sensitive to changes in base interest rates.
In fact, even a half-percent seems like a fair amount, compared to today’s low starting levels. How high can rates climb? Bond investors selling their holdings cause prices to fall and rates to rise, often in anticipation of more inflation coming, coupled with stronger economic growth. On the other end of the teeter-totter sits the Fed, which is committed to keeping rates low by keeping bond-buying intact. The Fed is extremely sensitive to rate levels, particularly as they relate to borrowing costs (for consumers, businesses, and the government) so may use language and continuing operations to keep rates contained. (Jerome Powell was effective in doing this during his Senate testimony last week.) At some point, though, rates may have to move somewhat higher to keep pace with a normalization in inflation. This will require a careful balance as to not rattle risk markets. But, due to the longer-term slower growth influences mentioned, a sudden spike toward far higher rates does not appear to be a high-probability option, either. Of course, interest rates have the habit of being unpredictable and noisy, on the way to being self-correcting. If rates edge high enough to rattle equity markets, often a shift in investor preferences for low-risk assets can raise bond prices and pull rates back down again to some extent.
From a portfolio perspective, historical asset returns have been mixed during periods of inflation and/or rising rates, but are time-dependent, based on the amount of inflation, speed of increase, and period reviewed. It depends on whether inflation is occurring by itself, or is accompanying stronger growth, which markets reward. You might think bonds would perform terribly, and those with a very long duration can be hit with sharper immediate price losses, but broader bond market indexes that include a variety of bonds may show more tempered results. This happens as older bonds are retired and replaced with higher-yielding debt, which boosts future returns. If the environment of rising rates persists, being tilted a bit lower in duration and including assets such as floating rate bank loans may help, which takes advantage of rates resetting higher. Inflation is a mixed blessing for stocks, depending on location in the business and earnings growth cycle, which have been considered more important. Naturally, firms that are better able to pass higher input costs on to customers may fare better than those that cannot. Inflation could also be helpful to assets such as real estate, due to expectations of rising rents; and commodities, which are directly tied to higher goods prices, as well as a weaker dollar, if that were to continue.
As always, the fact that there are so many current questions about inflation in mainstream media make one think that inflation may not be the right question to be focusing on after all.
|Period ending 2/26/2021||1 Week (%)||YTD (%)|
|BBgBarc U.S. Aggregate||-0.36||-2.15|
|U.S. Treasury Yields||3 Mo.||2 Yr.||5 Yr.||10 Yr.||30 Yr.|
U.S. stocks declined across the board last week. The primary equity concern as of late appears to be less on the vaccine distribution (which is plugging along slowly in the U.S., and hampered by poor weather), but the incremental rise in interest rates across the middle and longer end of the curve. Thursday was an especially negative day, with more broad market concern over potential inflation pressures causing equity investors to question the current bull market recovery, and higher treasury rates.
By sector, energy gained over 4% along with strength in petroleum prices, while consumer discretionary, technology, and utilities were the worst-performing groups. The Nasdaq experienced its most severe decline in several months, as ‘long duration’ growth stocks were hit hardest by interest rate fears.
Foreign stocks in developed Europe and the U.K. fared slightly better than those in the U.S. A stronger British pound helped that region, as the recovery from Brexit is proceeding, lockdown removal plans are in place, and valuations there appear better than in other regions. Emerging markets declined sharply, by nearly -7%, led by weakness in Brazil and China. A stronger U.S. dollar and rising rates continues to often act as a headwind for EM nations, as it implies tighter liquidity and more difficult financing conditions.
U.S. bonds pulled back as the above-noted inflation concerns weighed on demand and pushed interest rates higher. Treasuries performed better than corporates, as spreads widened across the board. Foreign bonds performed negatively in developed and emerging markets as well, hampered by a rise in the U.S. dollar.
Commodities gained overall, despite the headwind of a rising dollar. This was led by gains in energy and agriculture, while precious metals fell back (gold’s relationship to inflation fears is inconsistent, but is generally inversely correlated to rising real yields). The price of crude oil rose by nearly 4% to $61.50/barrel, led by continued rising demand and contained supply. This offset a -7% drop in natural gas as the blizzard conditions nationwide tempered last week to more normal temperatures.