Following last week’s 6.2% inflation print, eurodollar futures fully priced in 0.75% of tightening by the end of next year. The approximate rate path envisages tapering by the summer, and rate hikes commencing around the same time. Beyond December ‘23 the curve is so flat that in effect the market expects the tightening cycle to be more or less completed, eighteen months after it began.

Ten year projected inflation edged up to 2.7% as derived from the treasury market. Although this is the highest it’s been, that figure doesn’t suggest the market believes inflation is out of control. With ten year treasuries still below 1.6%, it’s more accurate to say that the market expects the Fed to concede defeat on the transitory narrative and raise rates, even though the long term inflation outlook isn’t that far from the Fed’s 2% target.

The Fed may follow the market’s lead. The FOMC is notoriously poor at forecasting and for years projected a higher neutral rate than futures. Public comments suggest increasing discomfort among some FOMC members with persistently elevation inflation.

And yet, with their new policy regime targeting maximum employment with increased tolerance for a short term inflation overshoot, reversing the improvements achieved in the labor market will be a tough pill to swallow. The Warren/AOC wing of the Democrat party is likely to be a vocal critic of rising rates.

Hence the Administration’s growing focus on inflation. Although higher energy prices and supply constraints are two major symptoms, the real cause is surging demand boosted by the $1.9TN covid relief stimulus passed shortly after Biden’s inauguration. This is seen most clearly in the overshoot of personal consumption expenditures on all goods.

White House discussions with companies about logistics and pleas to OPEC to raise production overlook the fact that the US fiscal response to Covid was initially correct but became profligate once the welcome vaccine news was released a year ago. Both Congress and the Fed have overdone it.

Modern Monetary Theory (MMT) holds that because a government cannot go bankrupt in its own currency, deficits don’t matter. The constraint on unlimited fiscal largesse is found when Federal spending outruns the economy’s ability to provide goods and services without causing inflation.  We have found that limit – and Congressional Democrats appear set on pushing even further unless Joe Manchin provides a brake.

MMT purists should by now be advocating fiscal restraint to offset the uber-stimulus, but they will not. So the White House sees a brief window to convince Americans they have inflation under control, before they fear the Fed will be compelled to act. The market forecast of three 2022 tightenings by next year may be right, but this is a very dovish FOMC. There isn’t much economic pressure for a Fed response, since bond yields remain low and stock prices close to all-time highs.

Some economists think the Fed should tighten. The market is conceding they will but not for long. The yield curve is at the extreme. It wouldn’t take much to cast doubt on the projected 0.75% of hikes next year.

Many readers enjoy the travel photos from past trips, so see below from last week. The Grand Canyon needs no explanation – we hiked in both directions along the south rim trail and each view was more spectacular than the last. National parks have a mask mandate indoors that even extends to certain outdoor areas too. It was mildly irritating and widely ignored.

Several people recommended a visit to Sedona. Boynton Canyon with its sheer red rock walls attracts hikers, many of whom find the location spiritual and settle down to meditate. Someone we met referred to it as “Everyone’s Cathedral”.

We ended in Las Vegas, and what happened in Vegas will remain in Vegas. I am not a gambler – it’s hard enough finding attractive odds in financial markets. When I told one friend that losing $50 in a casino would ruin my day, he said I’d be unlikely to find a table offering such low stakes.

The pipeline sector and inflation trades offers far better odds.

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

Please see important Legal Disclosures.

Pipeline earnings last week provided further support for the bull market in energy. Cheniere is +67% so far this year. The strong global market for Liquified Natural Gas (LNG) caused them to increase their 2021 EBITDA guidance to a midpoint of $4.8BN, up $0.1BN. They also provided 2022 guidance of $5.8-6.3BN. The company has signed several long-term LNG contracts recently – Friday’s press release announced a 17 year deal with Sinochem to provide up to 1.8 million tons per annum. In recent weeks they’ve announced 13 year deals with Glencore and ENN LNG of Singapore.

Cheniere continues to be an attractive investment in spite of this year’s sharp rise. The completion of a sixth “train” (the name given to an LNG liquefaction unit) at Sabine Pass looks to be on track for 1Q22. Their growth capex needs are falling sharply, which driving free cash flow.

Morgan Stanley produces a chart of estimated sustaining capex as a % of EBITDA – what each company needs to reinvest annually to maintain its profitability. Cheniere’s situation is the best in the industry. Their stock price doesn’t yet reflect these very strong fundamentals.

The energy crisis engulfing much of the world has prompted Asian buyers to lock in long term supplies of LNG. It demonstrates that natural gas is uniquely situated among fossil fuels to benefit from the energy transition – when burned it generates typically a third to a half less CO2 than coal and doesn’t cause the same type of local pollution. Natural gas power plants are also easy to start up when weather-dependent renewables suddenly stop producing.

Alex Epstein, who wrote The Moral Case for Fossil Fuels and routinely exposes the sloppy thinking of environmental extremists, refers to solar and wind an “unreliables”. Epstein lives in California, so has some experience with expensive and unreliable power. The Golden State recently announced plans to increase its natural gas storage capacity to assure reliable power this winter. They’re finding the limits to weather-dependent power.

Oil and gas are higher because of rebounding demand, but the energy transition is another important factor. For years public policy and climate extremists have warned of stranded assets as renewables render reserves of traditional fuels uneconomic. Al Gore, who’s been warning us about climate change for decades, describes oil and gas reserves as “a subprime carbon bubble of $22 trillion, based on an absurd assumption that all of those carbon fuels are going to be burned.” Although Al Gore doesn’t drive energy sector capital allocation, extreme views like his are boosting returns by curbing new investments.

High energy prices are contributing to elevated inflation. Although Fed chair Jay Powell is retaining the “transitory” narrative, supply chain problems did not drive LNG shipments as high as $56 per million BTUs in Asia (see Energy Demand Drives Earnings Higher). Equivalent US prices are under $6. Pipeline investments have performed well as a hedge against inflation since the market low of March 2020. Although the S&P500 has rallied strongly since then, the American Energy Independence Index (AEITR), representing the North American energy infrastructure sector, has a visually better fit with inflation expectation (defined here as ten year forward inflation derived from the yield on ten year treasuries minus TIPs).  Daily returns on the AEITR versus inflation are correlated at 0.43 during this time, versus only 0.31 for the S&P500.

In his press conference last week, Chair Jay Powell once again emphasized that the FOMC expects inflation to moderate, although some commentators assessed slightly less conviction in his delivery. Eurodollar futures continue to forecast short term rates 0.65% higher by the end of next year, although a week ago expectations were even higher. The sharp flattening of the yield curve in several markets appears to be at least partially due to some hedge funds exiting losing trades in a hurry (see Balyasny, BlueCrest, ExodusPoint Ground Traders Over Losses). Nonetheless, the market is still expecting the Fed to concede a policy error and quickly raise rates.

Compared with past interest rate cycles, the Fed is in a pretty good position. Neither the energy transition nor drawn out supply problems are issues to be resolved by raising short term rates. Those states and countries that have high renewables penetration (California, UK and Germany) also have high prices. Efforts to reduce CO2 emissions will result in more costly power, and the Fed shows no inclination to lean against this.

Moreover, negative real yields on treasury securities are leading to persistent low interest rates. Although the Fed has made a mistake in waiting until now to curb its bond buying, there has been no visible penalty in terms of slumping bond prices. The traditional pressure from bond vigilantes is absent, because so much return-insensitive money is invested in fixed income. Stocks make new highs almost every day. So although financial professionals are taught about the evils of inflation from an early age, the pressure on the Fed that’s often cited is limited to criticism from Larry Summers and others. Absent any clear economic or market stress from rising inflation, the case for maintaining low rates until the pre-Covid level of employment is reached must seem compelling to Powell and many others on the FOMC.

What this means is that the Fed’s tolerance for inflation is likely to be higher than fixed income markets perceive. Combined with negative real rates, we’re a long way from where the bond market will offer an adequate return. This implies that stocks, and especially inflation-sensitive stocks, will remain the only plausible means of maintain purchasing power for a long time to come.

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

Please see important Legal Disclosures.

A significant interest rate move has taken place in recent days that has received scant coverage from mainstream financial media. The market has priced in a more aggressive pace of Fed tightening over the next couple of years, while simultaneously moderating the outlook beyond that. This flattening of the yield curve has been reflected in the spread between two and five year treasury securities, which reversed a steepening trend. The change in yields appears unremarkable. Eurodollar futures incorporate the same rate expectations but with greater precision, because they reflect market expectations of Fed monetary policy in three month increments.

Over just a few weeks, projected tightening of rates has been brought forward by at least a year. Ten year treasury yields have risen just a few basis point on the month, whereas eurodollar futures two years out have jumped 0.50%.

As a result, the trajectory of Fed policy has shifted even farther from guidance set out by the FOMC and many analysts.

For over a decade the Fed has sought to be more transparent about their decision making. This has included publishing minutes, holding regular press conferences and releasing projection materials on their economic outlook. The Fed’s projections have not always been accurate. The “dot plot” which sets out what FOMC members individually expect for short term rates has in the past been revised to match those reflected in the yield curve.

The Fed’s “neutral” rate is the level of Fed Funds at which they’re not seeking to provide stimulus or restraint. For many years it was 1-2% above long term bond yields, even though they should theoretically be similar (see Bond Investors Agree With the Fed…For Now). The two finally converged in 2018, mostly via the Fed consistently revising their figure down. The discrepancy returned after Covid and still exists today to a lesser degree.

The central bank’s past failure to correctly forecast its own actions is a source of amusement for those who pore over such minutia. Fed chair Jay Powell has said in the past that forecasters have much to be humble about, an observation most applicable to the FOMC.

So it’s not the first time the market and FOMC have disagreed. Based on history you’d have to favor the collective wisdom of millions of investors over the Fed, even though the latter makes the decisions. Nonetheless, futures prices now anticipate short term rates 0.65% higher by the end of next year. As recently as late September, nine of 18 FOMC members thought monetary policy would still be unchanged at that time.

The Fed continues to buy $120BN of bonds per month. Next week they’re expected to announce tapering, and past comments have suggested a measured reduction of $15BN per month which would take until June 2022 to complete. They won’t tighten while they’re still buying bonds, which would mean no sooner than 2H22. Market forecasts of earlier tightening rely on faster tapering or a series of rapid moves as soon as July.

Either scenario is at odds with an FOMC whose public comments maintain inflation is transitory and that the employment situation still needs improvement. Interest rate futures are priced for Jay Powell to express less confidence in the “transitory” narrative around inflation.

Wednesday’s press conference following the FOMC’s two-day meeting should resolve the discrepancy for now. If Jay Powell confirms market forecasts, that will represent a concession that earlier confidence on moderating inflation was misplaced. If he sticks with his theme, at least some of the recent curve flattening will reverse.

Recent data has been mixed. US 3Q GDP rose just 2%, held back by the delta virus in some states and continued supply difficulties. Apple’s earnings on Thursday were a case in point. But the Employment Cost Index rose 1.3% over the prior quarter, up 3.7% over the past year. Healthy wage growth suggests strong employment

Total employment of 147 million remains five million below pre-covid levels, a metric Powell has often cited as evidence that the employment component of their mandate remains unfulfilled. Nonetheless, record high job openings noted in last Sunday’s blog post (see Life Without The Bond Vigilantes) suggests demand for workers is being frustrated by a skills or location mismatch.

Rising energy prices are a predictable part of the energy transition (see Is The Energy Transition Inflationary?), even if progressives whose policies have constrained oil and gas supply won’t claim credit. Tighter monetary policy isn’t much help for consumers paying more to fill up their cars and heat their homes. The COP26 climate change meeting is well timed to grapple with the challenges unrealistic climate extremist energy policies have created.

The real issue is that consumption is running well ahead of trend, because the fiscal and monetary response to Covid was disproportionate. That could justify tighter policy, but isn’t a reason that’s received much attention.

A few central banks have already begun to withdraw stimulus. Canada abruptly stopped their bond buying last week. The UK’s Bank of England has said they may consider raising rates. Short term rates in Brazil have reached 7%.

Last week the European Central Bank (ECB) maintained their large bond buying program, and ECB President Lagarde said markets were incorrectly pricing in a tightening next year. Traders were non-plussed, and yields rose further. The Fed and the ECB are the two heavyweights not yet willing to abandon the transitory narrative.

Some commentators suggest that stubbornly elevated inflation may force central bankers to concede to the market’s forecast of higher rates, sooner. But the bond market has lost its ability to cower policymakers into submission. Persistently low bond yields and record high stock prices suggest that the Fed has plenty of time to continue their single-minded pursuit of maximum employment.

Next week’s Fed press conference and the conclusion of COP26 will provide important guidance for investors in bonds and energy.

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

“The Fed’s an inflation creator, not an inflation fighter.” So said Paul Tudor Jones last week in an interview on CNBC. It’s doubtful that charge has been leveled at the Fed in at least half a century. William McChesney Martin ran the Fed for almost 19 years (1951-70) during a period that set the stage for the inflation of the 1970s, so it’s possible contemporaries were similarly critical. But it’s not a criticism that could have been made of Paul Volcker, Alan Greenspan or Ben Bernanke. Janet Yellen also avoided such a label although as Treasury Secretary she’s a high profile cheerleader of current policy.

Larry Summers also weighed in, expressing concern at the Fed’s apparent embrace of climate change and income inequality as policy issues that should concern them. Summers argued the Fed should stick to their core mission of monetary policy – a task he believes they’re not mastering at present.

Faster tapering is the obvious change required of Fed policy. The Federal Reserve balance sheet sits at a record $8.5TN. Current expectations are for the Fed’s $120BN of monthly bond buying to be reduced by $15BN per month before the end of the year, which means they’ll add almost another half a trillion dollars to the world’s biggest balance sheet in the meantime.

It’s increasingly clear that the supporters of current monetary policy are an exclusive group living within the DC beltway and attending Democrat cocktail parties. Inflation doesn’t benefit any specific income group, but higher interest rates are never sought by the party in power and the Fed’s management of monetary policy no longer appears independent.

Job openings hit a new record in July — like the Fed’s balance sheet, this metric has doubled since the lows of Covid. The symmetry is compelling and one more confirmation that hiring is vibrant. Measuring the unemployed is straightforward since they file for unemployment – counting open jobs understates demand for workers, because many jobs aren’t advertised. Therefore, the unemployed usually exceed open jobs – which makes today’s situation so unusual.

With nearly 11 million positions open, the highest on record, and 8 million unemployed, it strongly suggests a mismatch between skills or location. Neither of these can be resolved by the blunt instrument of monetary policy.

In the past, a combination of rising inflation, tight labor market and easy monetary policy would have sent bonds into a tailspin. I well remember how in the summer of 1987 incoming Fed chair Alan Greenspan was regarded by some as a lightweight, unwilling to impose the tough interest rate medicine of his predecessor Paul Volcker. Establishing one’s “inflation fighting credentials” required responding to the bond vigilantes.

That’s no longer the case. Bonds long ago ceased to offer any value for return-oriented investors. Today’s buyers are central banks and others with inflexible investment mandates. Inflation doesn’t seem to curb their demand. Therefore, today’s FOMC is under no market-oriented pressure to respond to rising inflation fears, because bond yields remain low. Markets are nonetheless pricing in a faster tightening of monetary policy, as if the Fed’s transitory narrative on inflation will be abandoned. Low real rates, helped in part by the Fed’s own buying of bonds, are muting the messenger which affords them a more leisurely normalization of policy than might otherwise be the case.

Tightening sooner means less later. The yield curve has been flattening sharply, pricing in monetary policy more than 0.5% tighter than the FOMC’s projections within two years, yet lower than FOMC projections by 2025. It reflects the possibility of a policy error – the yield curve can be interpreted as warning of overly aggressive monetary tightening causing a slowdown in growth.

Fed officials have had little to say recently on this adjustment — future comments will need to either move away from the transitionary narrative or confirm they’re still comfortable.

In fact, it may be harder than many think for the Fed to slow the economy with higher rates. Ten year treasury yields at 1.6% already incorporate the anticipated loss of Fed buying of bonds next year, and short term rates at 1.5% within a couple of years. Long term rates would probably have to increase a couple of percent from here to have any significant economic impact. That would presumably require short term rates also a couple of percent higher than currently priced in.

Moreover, negative real yields on bonds mean that persistent inflation poses less of a financing problem for the Treasury — if inflation settled in at, say, 4%, today’s TIPs yields of –1% suggest the cost of US debt would gravitate towards 3%, which doesn’t seem that onerous.

It’s not hard to find support for modestly higher inflation (see America Needs Higher, Longer-Lasting Inflation for example), and if the government remains able to finance its enormous debt at rates below inflation, that could be an attractive outcome. The losers would be holders of low-yielding debt, which is foreign central banks, sovereign wealth funds and pension funds – not a group likely to attract much sympathy.

The bottom line is rates seem likely to rise slowly. Bond market concern about inflation is limited by return-agnostic buyers, and the FOMC has made clear their willingness to risk inflation for numerous objectives not limited to employment. Don’t look to this Fed to protect the dollar’s purchasing power.

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

The two front covers from The Economist, thirteen months apart, represent an overdue liberal education. Much of the mainstream press has heralded the energy transition to renewables as a source of jobs, innovation and everything else good including lower CO2 emissions. In September 2020 The Economist ran a leader titled Is it the end of the oil age? They excitedly continued, “As covid-19 struck the global economy earlier this year, demand for oil dropped by more than a fifth and prices collapsed. Since then there has been a jittery recovery, but a return to the old world is unlikely. Fossil-fuel producers are being forced to confront their vulnerabilities.”

Today, the US Energy Information Administration (EIA) expects total liquids demand to be 36% higher by 2050. OPEC expects crude oil demand in 2045 to be 108 million barrels per day, versus around 100 currently. In covering the energy crisis engulfing most of the world, The Economist now warns, “the first big energy scare of the green era is unfolding.”

It shouldn’t have been hard to see coming. Climate extremists have disingenuously promoted solar and wind as the only acceptable sources of electricity. They have glossed over intermittency and the reliance of weather-dependent energy on back-up (usually natural gas or coal) to make it work. They’ve ignored that electricity provides only 17% of the world’s energy, assuming that the other 83% could be electrified and all supplied by renewables.

Oil and gas production has been demonized to such an extent that public companies have pulled back from making new investments, causing today’s rising prices. Over 80% of the world’s energy comes from fossil fuels. Vaclav Smil, a prolific multi-disciplinary writer, has explained in detail why energy transitions take decades to play out, and why this one will be no different.

Finally, political leaders have been keen to demonstrate their green credentials by using every opportunity to curb new production of oil and gas, but hypocritically reluctant to welcome the higher oil and gas prices that result. Energy systems will shift mostly based on economic signals. With Europe and Asia paying 3-5X more for imports of liquified natural gas than a year ago from Qatar, Australia and the US, liberal politicians could claim that their policies are working. Instead, European leaders are pleading with Russia to dispatch more natural gas. President Biden wants OPEC to increase oil production even while he promotes policies to curtail domestic production.

With inconvenient timing, the COP26 climate change conference will be held next month in the UK, where coal plants have been restarted to compensate for a windless North Sea and prior policy decisions that slashed the UK’s natural gas storage capacity. Although energy prices are rising, nobody is bidding up solar panels or windmills.

We’ve been writing about the unrealistically narrow focus of climate policies for several years. Emerging economies want higher living standards, which mean increased energy consumption, more than they want to reduce CO2 levels. Climate extremists oppose everything that works even including nuclear. Advocates claim that solar and wind are the cheapest form of power, implying that utilities are stubbornly retaining legacy energy systems and foregoing higher profits in the process.

The juxtaposition of the two Economist front covers represents the start of a more realistic debate over the energy transition. Now their editors recognize that “the mix must shift from coal and oil to gas which has less than half the emissions of coal.” A year ago, The Economist argued that solar and wind could reach 50% of global power generation by 2050. Last week, the EIA’s International Energy Outlook 2021 predicted a more sober 40% share. Even that figure relies on robust 8.7% and 4.7% annual growth for solar and wind respectively over the next three decades. Today’s chastened Economist editors now concede that, “More nuclear plants, the capture and storage of carbon dioxide, or both, are vital to supply a baseload of clean, reliable power.” A year ago they mentioned neither.

Most people who give the issue much thought favor reduced CO2 emissions. But political discourse has been simplistic, which has led to bad policy. Germany and California are leaders in renewable power. Their residents pay the world’s highest electricity prices and in the Golden state suffer third world reliability. Sales of diesel-powered generators have risen 22% in California in the past year, as residents seek protection from their unreliable grid. Nobody should want to emulate their model. Meanwhile China goes on burning half the world’s coal and producing 28% of emissions, content to sell OECD countries the solar panels and windmills they crave.

Transitioning to an energy system that generates less CO2 will be very expensive – if it’s worth doing, it’s worth the cost. Policymakers should be honest with voters and explain why concern about climate change means accepting higher energy prices. We should be using more nuclear; switching from coal to gas; using carbon capture; introducing hydrogen; and including solar and wind only to the point where relying on their opportunistic supply model doesn’t destabilize power markets.

An example of new technology is Air Products, which is building a “blue hydrogen” plant that will produce 750 million cubic feet per day. For reference, the US produces around 90 billion cubic feet per day of natural gas. The new facility will use natural gas as feedstock, and sequester the resulting CO2 underground.

Hydrogen is expensive to produce, so initiatives like this need higher energy prices in order to compete. Democrat policies are helping do just that, even if their political leaders won’t take the credit. For energy investors, the unfolding energy crisis is great news. As public policy becomes more realistic, the outlook for natural gas and US midstream infrastructure keeps improving.

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