In Fed chair Jay Powell’s closing speech from the virtual Jackson Hole symposium he went to great pains to illustrate that currently elevated inflation is transitory. He compared the strong rebound in spending on durable goods to above its pre-Covid trend with services spending, which remains 7% below its pre-Covid trend. He noted the unevenness of the recovery from the shortest, sharpest recession in history.

Jay Powell remains convinced that inflation will moderate, and surveys of inflation expectations can be interpreted as supporting this view. Market forecasts of inflation derived from treasury securities have moderated recently. With the Fed is buying over half of new treasury supply, market rates are far from being set freely (see Behind The Fed’s Benign Inflation Outlook).

Since the FOMC believes the bond market is still in need of their support, they must also believe that yields would otherwise be higher. If so, they should draw scant comfort from such inflation expectations, but the Fed nonetheless relies on this circular argument for comfort. The University of Michigan Consumer Survey has not yet shown signs of moderating.

Towards the end of his speech. Chair Powell briefly reviewed the experience from 1950 to the early 1980s, a period that, “taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation.”

It’s hard to be sure that anything is permanent until it’s continued for a long time, including higher inflation. This stance is provoking criticism. “The Fed has tied its hands to be quite late to remove monetary-policy accommodation,” says William Dudley, former president of the New York Fed in a recent Economist article.

This is an unfortunate moment for the Fed to be implementing its new doctrine, revised following last year’s Jackson Hole symposium, of being more tolerant of higher inflation and therefore more reactive. History offers policymakers scant insight into how economies emerge from a pandemic.

Inflation may conform to the Fed’s benign outlook. If it doesn’t, the cause will be partly traced to Congress. Budget deficits of above $1TN will soon become the norm. While this year we’re on track to hit $3TN before falling sharply, the CBO forecasts deficits will begin increasing again by 2025. The President’s current budget proposal will add $12TN to the deficit over the next decade. This is why the Fed is likely to remain a significant buyer of US treasuries.

A Fed with a more acute sense of risk would use this relentless fiscal stimulus to support a hastier return to more normal monetary conditions. Congress has adopted Modern Monetary Theory (MMT, aka the  Magic Money Tree) philosophy of guilt-free largesse (see Democrats Will Test The Limits On Spending). Continued monetary stimulus leaves little room for error if the Fed’s inflation outlook turns out wrong.

Financial markets are embracing a more dovish Fed by pushing down the yields on eurodollar futures two years out and longer. Oddly, the market still expects one tightening of monetary policy by the end of next year, even while rate forecasts farther out have sunk below even the most Dovish FOMC members’ blue dots.

A reduction of bond buying, even if it begins in September, will likely mean the Fed’s balance sheet will continue to grow at least into 1Q22. In his speech last week, Powell said that, “…we will continue to hold the target range for the federal funds rate at its current level until the economy reaches conditions consistent with maximum employment…” He also noted that, “In the United States, unemployment ran below 4 percent for about two years before the pandemic, while inflation ran at or below 2 percent. Wages did move up across the income spectrum.”

From these statements it’s clear the Fed won’t raise rates until the unemployment rate is solidly below 4%. It’s likely they will await evidence of wage inflation before concluding full employment has been reached.

Everything about this FOMC argues for sloth-like policy normalization combined with a high roller’s embrace of substantial risk of a policy error. This is all to ensure that everyone who wants a job has one. Among the papers distributed to Jackson Hole attendees was Monetary Policy in Times of Structural Reallocation. Powell has argued that inflation has been caused by disruption of supply chains induced by Covid. The inference is that some corporations will need to restructure their logistics to accommodate a new world where lockdowns can occur with little notice. Once done, price hikes due to supply disruptions should dissipate.

The paper posits that higher inflation allows greater variation in real wages, which can hasten such restructuring. Since wages rarely shrink in nominal terms, higher inflation can accelerate the movement of workers to more logistically-efficient jobs. Inflation and wage hikes of 5% in growing sectors combined with low or zero nominal wage growth in shrinking ones would quickly widen real wage differentials, motivating workers to switch jobs accordingly. Higher inflation allows for a bigger drop in real incomes – getting a 1% raise with 5% inflation is a 4% cut in real wages, something not easily achieved with, say, 2% inflation.

Jay Powell didn’t broach the topic, but a dovish, risk-tolerant Fed focused on its employment mandate might find elements to like in such an approach.

There seems little reason for interest rate futures to plot a different course than the FOMC’s own dot plot – the odds of monetary tightening next year are receding. Circumstances may evolve to compel the Fed to “… respond and use our tools to assure that inflation runs at levels that are consistent with our goal.” If so, rates will eventually need to move higher than is currently priced in. That remains some way off.

To learn why you should worry about inflation, watch this brief video.

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

Energy Mutual Fund Energy ETF Real Assets Fund

 

Memories of the 2013 “Taper Tantrum” loom over today’s FOMC as they engineer an exit that will hopefully be more elegant than our current one from Afghanistan. Both were well overdue, although there is no doubt the military withdrawal was handled disastrously. Can the Fed do better?

Unlike the Afghan army, the bond market has reacted well to the approaching loss of US government support. Treasury yields even dropped modestly on the week, with the ten-year still around 1.25%, 0.50% below its high in late March.

Real yields have stayed below –1.0%, with implied ten-year inflation (nominal yields less TIPs) of 2.3%. Since the Fed’s bond buying will be over within 6-9 months, today’s yields must reflect close to an equilibrium level for a bond market operating without the crutch of partial debt monetization.

Persistently low long-term interest rates remains one of the most important drivers of valuations. Japan holds $1.3TN in US treasury securities, and China over $1TN. These and other holders are clearly not seeking generous returns. Moreover, the specter of foreign investors dumping bonds and causing a recession has gone. Our second stint of Quantitative Easing (QE) shows that the Fed is a fully capable buyer of last resort. China’s position would sit comfortable alongside the other $8TN on the Fed’s balance sheet. Whatever risk premium bond yields once offered against such a possibility has evaporated.

The bond market’s positive response to tapering is more accurately a reflection of concern over the Delta virus. Cyclical stocks have been under pressure since mid-June, and on Thursday the S&P Energy ETF (XLE) dipped below the 200-day moving average. There are signs that Covid is flattering the bond market’s apparent equanimity over tapering. Nonetheless, the Fed stepping back when there’s clearly ample demand for bonds represents a more elegant exit than waiting until yields had risen to, say, 2%.

The eurodollar yield curve has flattened over the past couple of months as bond yields have drifted lower. Market interest rate forecasts are now solidly below those of the FOMC. Five years out, even the most dovish of the “blue dots” that indicate individual FOMC members’ rate forecasts is almost 0.40% above the market. Although bond investors have pushed yields lower in response to rising hospitalizations from the Delta virus, it’s unlikely FOMC members’ rate forecasts have altered much two to five years out. And the market is still forecasting around one tightening per year from 2023, about half the pace of FOMC members.

Given their explicitly reactive posture, it’s quite likely that the FOMC will be slow to normalize rates. Chair Powell never misses an opportunity to remind us that achieving full employment, which means an unemployment rate at least as low as the January 2020 pre-Covid level of 3.8%, is their objective. It’s likely that the FOMC will rely on emerging wage inflation as confirmation we’ve reached full employment. So they’ll be playing catch-up, which is why the current flatness of the eurodollar curve seems incorrect. Put another way, with the market priced for two tightenings during 2024-25, we think three is more likely than one, and four a decent possibility.

Interest rate futures reflect a slow pace of easing at odds with FOMC forecasts and past history. Given that a philosophy of unlimited spending now drives fiscal policy (see Modern Monetary Theory Goes Mainstream), if the lethargic pace of tightenings turns out to be accurate, there wil be ever greater calls for additional fiscal stimulus to boost economic growth.

It began with the Greenspan put, and successive Fed chairs have been awarded the same moniker. Add to that the Biden put. At the first sign of economic weakness the call will go out for more spending, which remains virtually costless. With debt funded at negative real rates, it almost seems irresponsible to not take advantage of the opportunity.

In 2008 Ben Bernanke revealed the limitless balance sheet capacity of the Federal Reserve, which has moved from $2TN to $8TN since then with no discernible disadvantage to the US economy. Covid-induced fiscal stimulus ushered in Modern Monetary Theory (MMT) as mainstream policy, exploiting a country’s unlimited ability to borrow in its own currency.

Now that Congress has discovered the Magic Money Tree (i.e. MMT), the conditions that justify super-stimulus will become steadily relaxed, just as the use of QE will transition from an extraordinary measure to business as usual.

It’s against that context that the forecasts embedded in the interest rate futures market must be judged.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The most recent CPI report was a little better than expected – all-items less food and energy was up 4.3% year-on-year. Used car prices had boosted prior inflation figures but were up just 0.2% in July. Owners’ Equivalent Rent (OER), the statistician’s’ quixotic means of measuring what it costs to attain shelter through home ownership, rose just 0.29% in July. It’s up 2.1% over the past year, compared with the Case Shiller National Home Price index which is +16.6% through May (most recent available).

CPI is important because it’s used to make cost of living adjustments to social security and other government transfer payments. It’s part of the return on inflation—linked bonds and is often used in long-term commercial contracts to make price adjustments. But it’s becoming less relevant as target against which to grow your income. Investing is all about retaining purchasing power for the future. Most interpret this as being able to afford in ten years what you could buy today. It turns out that’s CPI is inadequate for this.

Because incomes grow faster than inflation, if your income fails to keep up with the median, you’ll be relatively poorer. Savers don’t just want to maintain today’s absolute purchasing power – they want to keep the same relative consumption as their peers. If you enjoy the median income today, growing it at CPI means falling below the median, and won’t feel like much fun. Average income has been dragged above the median by “the 1%”, or the increasing income inequality we often read about. So using the median provides a more representative figure for the typical family.

Whenever a writer quotes a price for something decades ago and converts it into “today’s dollars”, he’s using the CPI inflation rate. This understates the effective cost, because it fails to account for the fact that incomes have been rising after inflation. It doesn’t fully capture the chunk of income it cost the median household. For example, a new car in 1953 cost $1,850, which is $17,531 today after adjusting for CPI inflation.

You won’t get much new car for that today – Kelley’s Blue Book reports the average new car costs just over $40K. This is not much different than $37,511, the 1953 price adjusted by income growth. In other words, the average new car cost 44% of the median household’s income in 1953, and it’s 47% today. In relative terms, cars have kept track with incomes, not inflation. Milk and most groceries are much cheaper. Food commands less of a household budget than in the past. Color TVs are dramatically cheaper because they were only just being produced in the early 1950s.

Electronic goods such as TVs have long experienced deflation, because as their quality has improved the Bureau of Labor Statistics (BLS) converts this into a price drop. The CPI measures a basket of goods and services of constant utility, and a better TV at the same price is like a price cut. They try to adjust for the countless quality improvements that market economies deliver. The problem is that this kind of price cut doesn’t free up any cash to buy anything else. The BLS regards TVs as having fallen in price, even if the actual cost hasn’t.

Most products become better over time, and government statisticians expend much effort converting those improvements into imputed price cuts that don’t make you richer even if they add utility. It’s another example of the inflation statistics being theoretically correct and increasingly out of touch with people’s lives.

The average new home costs a little over 4X median household income, not much different than in 1953 although this is twice as much as if houses had simply risen with CPI inflation.

The Financial Times ran an article last week (see Why central bankers keep their cool over rising house prices) which found that separating out the value of shelter that home ownership provides is widely accepted by economists. The US isn’t alone in using a non-cash theoretical input for housing in its inflation statistics.

The article goes on to note that central bankers don’t worry about housing inflation because it rarely shows up in OER and its foreign equivalents. It’s a circular argument – OER is low because it’s not measuring the cash cost of home ownership, and therefore appears well behaved.

Median family incomes have always grown faster than inflation, but that gap has widened in recent years. Over the past decade, incomes grew twice as fast as inflation. This is mostly good news, because higher real incomes mean higher living standards. It’s bad news only for those whose incomes are tied to inflation since they’re slipping behind their peers at a faster rate than before.

The inflation statistics remain important for financial markets and those whose incomes are linked to it, but are steadily losing relevance for anyone who’s saving for the future.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The fall in treasury yields can be misinterpreted as implying that inflation expectations are moderating. Although ten-year treasury yields have dropped 0.40% over the past three months, almost all of that has been through lower TIPs yields. Inflation expectations (nominal yields minus TIPs) have hardly budged.

Given the Fed’s outsized role in the bond market, it’s hard to discern market expectations absent their activity. They’re buying 54% of all net supply this year, and as we noted a couple of weeks ago (see Behind The Fed’s Benign Inflation Outlook) they bought 85% of net new supply in July. Over the next couple of months, reduced maturities and increased issuance combined with the Fed’s regular $80BN in monthly purchases will draw on increased purchases by others to balance the market.

Friday’s payroll report kept us on the interminable path towards tapering and an eventual cessation of Fed debt monetization. Former NY Fed president Bill Dudley was interviewed on Bloomberg and noted that restoring the Fed’s $8TN balance sheet to more normal levels will take many years.

Prior to 2008, quantitative easing via Fed buying of bonds was an unknown tool. Former Fed chair Ben Bernanke unlocked it to good effect, but the Fed’s balance sheet continued to grow for several years after the 2008-09 financial crisis. It took almost a decade for assets to start rolling off meaningfully. Covid hit within a year, and the Fed’s assets soon doubled.

It is a partial monetization of our debt, no matter how Fed chair Powell may describe it otherwise. Society’s tolerance for this is one more proof that inflation has few opponents nowadays. Monetary policy aims, “to achieve inflation moderately above 2 percent for some time” according to the FOMC’s most recent statement, and the bond buying will continue until, “substantial further progress has been made toward its maximum employment and price stability goals.”

While the Fed aims to boost inflation, fiscal policy is striving for the same. The $1TN infrastructure plan working its way through Congress will add $256BN to the deficit according to the non-partisan Congressional Budget Office, even though negotiators claimed that it would be revenue neutral.

Expect very little outcry over this, since low bond yields reflect the inconsequential cost. With fiscal hawks long gone, excessive deficit spending will continue until it causes inflation. The stock market’s brief pullback in mid-July was arrested in part because of the “Biden put” — a severe drop in economic activity would draw another multi-$TN fiscal stimulus.

Although bond yields have remained near their recent lows, eurodollar futures yields rose during the week as the odds of a tightening in short term rates by the end of next year increased.

The yield curve nonetheless remains too flat. Median FOMC projections of short-term rates as well as the most dovish forecasts both suggest a sharper rate of increase from 2023 on. The FOMC’s forecasting record is abjectly poor. But this Fed is unashamedly dovish, so FOMC forecasts that are more aggressive than the market continue to look like an opportunity to bet with the FOMC by positioning for a steeper yield curve in eurodollars 2023-25, or that the 0.55% spread between two and five year treasuries is too narrow.

In other news, the Economist magazine recently ran a piece called A 3°C world has no safe place. It presented a sober contrast between the (mostly unmet) pledges of countries to reduce CO2 emissions and the scientific modeling that predicts the consequences. Rich countries committed $100BN per year to help developing countries adapt, although even this sum has not been delivered. Even though such promised transfer payments get virtually no coverage in US media, political leaders in countries like South Africa can be found on TV telling viewers that much larger sums are needed to pay for the energy transition.

As we noted in a recent podcast (Episode 79: The Bill For The Energy Transition), South Africa believes $750BN per year is needed from OECD to emerging economies, which would work out to $250BN from the US if apportioned among rich countries based on relative GDP. This is almost 4X what we spend on Medicare and Health, or over 40% of our defense budget. It’s as well that such discussion doesn’t make it to the US, because it would at a minimum cast a pall over the Adminstration’s excited talk about green growth opportunities.

One of the most striking features of the Economist article was how slowly the climate changes. Models, which have a checkered past of making climate predictions although presumably are better today than ever, forecast dire consequences by 2100. None of the people likely to be impacted by this can read the article, while the people who must make sacrifices in the meantime to reduce emissions will have mostly died by then.

It’s why developing countries like China and India are more concerned about increased energy use to raise living standards now, and don’t share the concern of OECD countries about global warming.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The link with crude oil is a familiar topic for investors in pipelines, who have often been told that the two are uncorrelated only to experience both inconveniently plunging together.

Since the Covid bottom in March, crude oil and midstream energy infrastructure have conveniently tracked each other higher – until the last several weeks during which the sector has slid while crude oil has held its gains. Visually, the last 16 months looks as if the two are closely linked. But the correlation of daily returns over that period is surprisingly low at only 0.28.

Episodes such as April 2020, when the two diverged sharply as crude went briefly negative, have an outsized impact on this statistic. As we’ve also noted, 2020 operating performance for most big pipeline companies came in within a few % of pre-Covid operating performance. It remains the case that stock prices move far more with oil than cash flows.

One reason for the relative weakness in midstream recently has been the drop in bond yields. The rise in inflation expectations increased interest in businesses with pricing power, and many pipelines have agreements that link price hikes to PPI. The ability to increase prices with inflation used to be an attractive feature years ago when MLPs were bought for their stable yields.

The volatility ushered in by the Shale Revolution took focus elsewhere, but this feature of contracts has remained and will likely become more important in the years ahead. In research last month (see Market Underprices Rate Hike Risks), Wells Fargo calculated that 60% of midstream EBITDA was exposed to inflation escalators, and with a 5.5% 2021 PPI estimate they calculated a 3% lift to sector EBITDA.

The recent moderation in inflation fears reflected in lower bond yields has similarly depressed the pipeline sector. This is likely to be temporary. As we noted last week, Fed bond buying took up almost all available net new supply in July (see Behind The Fed’s Benign Inflation Outlook). Inflation concerns are everywhere, with both fiscal and monetary policy being managed without regard to rising prices. The government will get what it wants, and the coincident drop in bond yields and pipelines serves to confirm the latter’s use as protection against inflation.

On a different topic, the International Energy Agency (IEA) recently issued a report on global electricity demand growth. It’s easy to conclude that renewables will soon be providing the majority of our power based on today’s popular press. The IEA noted that global electricity demand is increasing faster than renewables-supplied power. Since the power sector is renewables’ most important target, inability to even match demand growth reveals how unrealistic it is to think windmills and solar panels are going to fully solve the problem of climate change.

Moreover, because the growth in global electricity demand is centered in emerging Asia where coal use is high, this dirtiest form of energy is benefitting from strong demand. China represents half the worlds’s growth in power demand. Even last year they saw healthy growth, contrasting with widespread reductions due to Covid.

40% of this year’s growth in electricity demand will be provided by coal. China’s refusal to agree to a G20 communique phasing out coal is easily understood when considered alongside these figures from the IEA.

Even though coal continues to retain its outsized share of world electricity production, the opportunity for natural gas to offer a meaningful alternative remains immense.

Tellurian CEO Charif Souki mentioned this in a recent video. Confirming the positive long term outlook for natural gas, Shell became the third company to sign up with Tellurian to purchase 3 million tons per annum of natural gas.

The American Energy Independence Index (AEITR) includes North America’s biggest pipeline companies. We believe the sector offers solid inflation protection as well as continued upside from growing global demand for US natural gas.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

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

Energy Mutual Fund Energy ETF Real Assets Fund