Last week Fed chair Jay Powell pivoted away from “transitory”, and adopted a tone more in keeping with the market’s newly revised interest rate forecast. As a result, today’s yield curve is far away from the September FOMC projections, even though they’ll be revised at this month’s meeting.

The most important question for bond investors must be the persistence of negative real rates – currently around –1.0% on the ten year. Moreover, the market has lowered expected short term rates five years out compared with their level at the September FOMC (the last time they issued projections materials). The biggest change in the meantime has been the Fed’s assessment of the inflation outlook.

Real rates have been declining for years, and so has the economy’s resilience to high rates. The eurodollar curve is currently priced for the Fed Funds rate to peak in two years at around 1.5% and for policy to remain on hold from then on. Ten year treasury yields are inexplicably at 1.4%, with inflation running over 6% year-on-year, tapering set to begin and the Fed likely to raise rates as soon as next spring if they decide to accelerate tapering later this month.

It doesn’t seem likely that the Fed will be able to restrain economic growth much without seeing long term yields rise. A 1.5% peak Fed Funds rate probably isn’t enough.

Former NY Fed president Bill Dudley recently commented that the market was extremely sanguine about how little increase in rate will be necessary to curb inflation. Five year inflation expectations derived from the treasury yield curve are 2.7%, and ten years 2.5%.

Add it all up, and the market is priced for Fed Funds to peak at 1% or so below inflation, which is nonetheless expected to moderate without monetary policy becoming restrictive. If someone articulated such an outlook, they’d be regarded as impossibly optimistic, yet it’s the market forecast.

One of the great pleasures of writing this blog is receiving comments on it. I remain in touch with many former colleagues and business associates as a result. Last week our post on the Owners’ Equivalent Rent, or OER (see The Subtle Inflation Pressure From Housing) drew an emailed response from Donald H. Layton, former CEO of Freddie Mac from May 2012 until June 2019. Now that he is enjoying a well-earned, though still typically industrious, retirement Don is writing papers on public policy with respect to housing. He has much to offer on the subject.

For 14 years of my 23 year JPMorgan career (1986-2000) I worked under Don Layton. As vice chair, Don led global capital markets and investment banking, which included my business of US interest rate derivatives trading.

Don is one of those rare executives able to combine strategic vision with an intense focus on detail. He often kept managers on their toes by revealing more knowledge about their business unit than might be expected from one of the bank’s top three executives. He was a superb leader who inspired loyalty and respect in equal measure. To my great pleasure we have remained in touch, and our annual reunions on the golf course followed by lunch inevitably include thought-provoking discussions about finance.

A couple of months ago Don wrote an excellent blog post about OER (see What Do Runaway House Prices Mean For The US?). He noted three disadvantages of the current housing boom: increasing inequality (if you don’t own a home and/or stocks, you’re slipping farther behind the asset-owning classes); decreased home ownership (it’s harder than ever for first time homebuyers) and artificially lowering inflation (because OER fails to adequately reflect the costs of home ownership, especially for current buyers).

Don noted, as we often have on this blog, the problems with estimating the cost of shelter by surveying homeowners on the possible rental income they might earn on their home. He notes that, “while the FHFA (Federal Housing Finance Agency) is saying that house prices went up 19.2 percent over the past year, the OER says that the cost of shelter for owner-occupied homes went up by only 2.43 percent! That’s a lower percentage increase than even for the median rent of an actual rental unit.”

Don goes on to argue that, “This result fails the common sense “smell test. The OER approach may work adequately well in normal times, but it does not seem to be working properly under the stress of today’s unprecedented increases in house prices.

“Unfortunately, given the high percentage of the typical household budget that is taken up by shelter, claims of today’s inflation being transitory may therefore not be well-founded. This suggests that policymakers are flying more than a bit blind, not seeing the inflation that the citizenry feels (especially those looking to buy their first home). That does not bode well for those policymakers, especially at the Federal Reserve, making the best decisions.”

US monetary policy would be better served if such clear thinking was more prevalent among policymakers.

CPI inflation is likely to remain stubbornly higher than the FOMC might like as home price appreciation filters through to rent, and their theoretical analog OER. Market forecasts of a peak in the Fed Funds rate of 1.5% seem very optimistic.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Please sign up here for our webinar, Making Sense of Rising Inflation and the Global Energy Crisis, on Thursday, December 16 at 12 noon Eastern.

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.