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Allianz SE’s Mohamed El-Erian recently said the, “Transitory Inflation Call Likely Fed’s Worst Ever.” There is some competition for that title. Just in my career (1980-) you’d have to include Alan Greenspan’s summer 1987 tightening which was soon followed by the October 1987 Crash; Greenspan’s assessment that the internet had boosted productivity, which underpinned easy late 90s policy; and Greenspan’s laissez-faire approach to regulatory oversight which helped cause the 2008-9 Great Financial Crisis (GFC). Greenspan made a few mistakes, but he was Fed chair from 1987-2006, so he had plenty of time. And he got much more right than wrong.

But the Fed’s imminent concession that they misread inflation earlier this year exceeds those three, and probably any that came before. Today’s FOMC announcement will likely see them start to correct, but unless the Fed immediately stops buying bonds they’ll still be moving too slowly – maintaining bond market support for an economy that long ago ceased needing it.

“Worst Call Ever” is justified because Fed chair Powell’s equanimity over inflation was so obviously misplaced. Like many observers, we saw reasons to be concerned a year ago (see Deficit Spending May Yet Cause Inflation). Earlier this year, Congress passed the American Rescue Plan, $1.9TN of further stimulus not needed since vaccine distribution was already underway. Through this, the FOMC maintained its pro-cyclical monetary policy and continued to finance most of America’s mortgage origination.

Even Democrat lawmakers have begun pushing the Fed to tighten policy (see US Democrats push Fed for tougher action against inflation). Representative Jay Auchincloss (D-MA) is an example of Congressional muddled thinking – he supported the abovementioned $1.9TN profligacy but now says, “The Fed needs to start tapering immediately and then they need to raise interest rates.”

This is exactly why Modern Monetary Theory (MMT) is flawed – the notion that Congress should increase deficit spending until it’s inflationary assumes they’ll curb largesse in time, which they obviously haven’t (see Reviewing The Deficit Myth, Stephanie Kelton’s support of MMT which unwittingly reveals its flaws). When members of the party in power want the Fed to tighten to offset their fiscal mistakes, you know there isn’t much hard thinking going on. Somehow Auchincloss is a member of the House of Representatives financial services committee, which oversees monetary policy.

The sad truth is that the Federal government’s 2021 fiscal and monetary approach to Covid was dead wrong. By contrast, the government’s response to the GFC was broadly correct, and impactful. Then Fed-chair Bernanke introduced Quantitative Easing (QE), using the Fed’s balance sheet to buy $TNs of bonds. This was a bold and controversial move, but Bernanke was right in arguing it wouldn’t be inflationary. That might be the best call ever by a Fed chair. Jay Powell has simply incorporated QE into the Fed’s toolkit, but with the opposite result.

It’s likely the FOMC’s “dot plot” will move up towards eurodollar futures. The market is priced for the Fed Funds rate to reach 1.5% and by 2023 and remain there. The implication is this will be sufficient to reduce inflation back to the Fed’s desired 2%-ish level. Tightening and tapering are both reflected in ten year treasury yields, which remain below 1.5%.

The assumption is that it will not take much for the Fed to tame inflation, and ten year inflation derived from TIPs has moderated from 2.75% to 2.45% in the past month.

Another possibility is that the inflation figures are losing relevance. The deep flaw in the CPI’s measure of housing costs is receiving more attention (see U.S. Home-Price Surge Looks Much Tamer in Government CPI Report). We regularly point out the flaws in Owners Equivalent Rent (see The Subtle Inflation Pressure From Housing).

When the survey-based method of cost of shelter finally rises, expect the Fed to dismiss it as a non-cash item. If other measures of inflation are moderating then, they’ll be unlikely to act on it.

We could be entering a period of permanently higher inflation – a function of the Fed’s revised policy of greater tolerance but also an increasing gap between reported inflation and what consumers experience. Stocks and other real assets are the only investment solution.

It’s many months since we wrote about Covid – it’s often tempting, and statistics are plentiful. But it can appear self-indulgent, since there’s no shortage of literature available from better qualified writers.

However, a recent New York Times article was so egregious as to demand attention. Always in need of depressing news, they reported that 1% of older Americans have died of Covid. To further demonstrate journalistic innumeracy, they noted that 590K, or 75% of Covid deaths were the over 65s. Forget “with Covid” versus “from Covid”. The media often conflates the two, although the CDC defines “All Deaths involving Covid-19 (italics added).

Putting aside with versus from, CDC data also shows that 4.7 million over 65s died from all causes since Covid began, 73% of the 6.4 million total. In other words, older people die at roughly the same rate regardless of Covid. 1% of older Americans have died with Covid since early last year, but 8% of older Americans have died from all causes.

A New York Times non-story shouldn’t matter, except when such a widely read news outlet makes news out of something that plainly isn’t, it gets people like Representative Jay Auchincloss to mistakenly vote for unneeded fiscal stimulus.

The current inflationary environment is a result of poor analysis and policy errors. With the same cast of characters in charge, Investors should be prepared for more.

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

Energy Mutual Fund Energy ETF Real Assets Fund

Please see important Legal Disclosures.

 

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.

For the past few months the eurodollar futures market has steadily priced in the FOMC’s abandonment of “transitory” in its assessment of inflation. More often than not the Fed follows the market. The typical absence of public comments that precedes FOMC meetings was extended while Biden contemplated renewing Powell’s term. In short order, Powell’s reappointment was announced, several Fed governors publicly contemplated faster tapering and the release of minutes revealed a lively debate. “Transitory” has become a derogatory adjective in finance betraying cognitive dissonance. As in, “The hedge fund manager described his losses from shorting meme stocks as transitory.” Something is transitory, until its permanence becomes painfully obvious.

President Biden and Fed chair Powell had their discussion during which no doubt Biden hoped for a lethargic policy response to inflation while Powell demurred. With Powell’s reappointment secure, all that was left was for the next FOMC meeting to make the taper briefer, in preparation for three to four rate hikes beginning next spring.

B.1.1.529, the new Covid mutation identified in South Africa, has scrambled everything. The World Health Organization has assigned it the Greek letter “Omicron” since that’s the next one in the alphabet. The $8 drop in crude oil will be welcomed by the Administration which will likely claim partial credit since it so closely followed the release from the Strategic Petroleum Reserve. Eurodollar futures removed one projected tightening from next year.

The energy sector modestly outpaced the S&P 500’s 2.2% fall, dropping 2.6% (defined as the American Energy Independence Index).

Last year when investors asked for our outlook on midstream energy infrastructure, we’d often note that the path of Covid would be an important factor. We all became amateur virologists in attempting to project investment returns. The vaccine ushered in economic growth powered by an excessive fiscal response, with the removal of monetary accommodation (albeit very late).

How much has changed?

As before, the near-term direction depends on the virus. If existing vaccines prove ineffective, economic activity will slow until a new one is created and distributed. Some fear the new mutation may require a new vaccine. It’s a science question not an economic one.

The pipeline sector has just reported solid 3Q21 earnings. Cash flows continue to grow, buoyed by recovering volumes and continued financial discipline. Progressive energy policies have been more constructive than expected – impeding sufficient supply of oil and natural gas has improved prices and sentiment. COP26 revealed the gulf that exists between the climate goals of OECD countries and the growth objectives of emerging countries. Unilateral policies to accelerate the energy transition increase prices for consumers and mostly serve to accommodate increased emissions from China, India and others.

Given the uncertain near-term direction, it can be helpful to remember the long-term growth outlook for US energy consumption. Although renewables command excessive media attention, the chart shows that the big energy story of the past decade was the huge drop in coal consumption which was mostly offset by increased natural gas.

The Energy Information Administration expects the US to increase consumption of renewables, natural gas and even petroleum products over the next three decades. “Other renewables”, which is mostly solar and wind, is forecast to grow from 7.5 quadrillion BTUs to 17.5 by 2050. Even then it’ll still provide less than half the energy of natural gas.

Energy transitions are slow, and forecasters have a long history of overestimating the speed of change. Just over four years ago we noted Tony Seba’s forecast (see A Futurist’s Vision of Energy) that by 2030 US consumers would only be buying Electric Vehicles (EVs). Their share is currently around 4%, with Tesla dominating. Although we expect EVs to grow like most forecasters, reaching one third market share (defined to include hybrids) as expected by LMC Automotive seems more realistic. Electricity produced from natural gas will still be the dominant source of power generation. Incidentally, Exxon Mobil’s 2030 EV market share forecast back in 2017 was 10% — likely to be low. Forecasting adoption rates for new technology is hard.

Near term market direction will depend on the Omicron variant. Over a year or more, we still expect the constructive fundamentals of the US energy sector, especially natural gas, to drive cash flows and stock prices higher.

Join us on Thursday, December 16^th at 12 noon Eastern for a webinar where we’ll provide an update on the midstream sector during rising inflation.

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

Energy Mutual Fund Energy ETF Real Assets Fund

Please see important Legal Disclosures.

 

 

It’s easy to criticize the Fed. They’ve maintained their uber-accommodative monetary policy for probably a year longer than needed. Once the vaccine breakthrough was announced last November, prudence dictated that they anticipate an economic rebound and begin normalizing rates.

Instead their bond buying has had the effect of partially monetizing Federal debt issued to fund the huge fiscal response to the pandemic. The March stimulus package was clearly an additional $1.9TN in buying power that consumers collectively didn’t need, which is why personal consumption expenditures on goods are running well above the long term trend.

The relevant quote from former Fed chair William McChesney Martin, Jr., as lifted from his written speech is, “The Federal Reserve…is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.” Instead, current chair Jay Powell and his colleagues have been pouring in the Absolut.

Housing is another example. The FOMC must be the only group of Americans unaware that suburban residential real estate is red hot, making it more expensive for the two thirds of American households who choose to own their home to find shelter. Owners’ Equivalent Rent (OER) allows them to pretend that nothing untoward is happening, in willful defiance of the S&P/Case-Shiller U.S. National Home Price Index (C-S).

By coincidence, since the last housing peak in July 2006 both indices have increased by approximately the same amount. The real estate market has felt a lot different to consumers versus the number crunchers at the Bureau of Labor Statistics who produce OER. They might even argue that this shows OER is a decent proxy for housing. However, the C-S is +20% over the past year.

The Fed is still buying $40BN of mortgage-backed securities every month. Even though they’re winding down, at their current tapering pace they won’t be completely out of the market until June.

It’s easy to criticize the Fed. Markets have priced in a significantly more rapid tightening than the most recent FOMC projection materials, with almost no public comments from officials that such was likely. With inflation running at 6.2% it’s easy to see why.

So it’s interesting to consider the defense of the Fed, one that the Fed chair may offer once Biden has announced his choice.

Reports that the White House is considering replacing Powell with Lael Brainard are likely all optics, and although some commentators perceive Brainard as more dovish, the FOMC has maintained the monetary gusher without much public dissent. They’re all doves.

It starts with financial markets – one of the more interesting recent charts is the one showing an unprecedented drop in the correlation between short term and long term rates. The bond market used to be a real-time measure of Fed policy, but inflation expectations and monetary policy seem to play less of a role than in the past. This may be why the correlation has dropped.

Anchored by central bank buying and other return-oblivious investors, bonds seem impervious to rising consumer prices.

Ten year treasuries at 1.6% are hardly onerous unless you think you’re entitled to a return on your money, a requirement bond investors have abandoned. TIPs yield –1.1%, so the ten year inflation expectation is 2.7%. This is somewhat higher than the Fed’s 2% target but not out of control, and not inconsistent with the Fed’s optimistically transitive narrative.

The recent shift in tightening expectations has been almost exclusively reflected in the short end of the curve. The precise market forecasts offered by eurodollar futures show that traders expect any tightening to be completed within two years or less, with stability thereafter. Ten year treasuries yield the same 1.6% as they did in May.

The Fed’s $8.5TN balance sheet has helped depress bond yields, but now the buying will slowly stop and the market knows that. There’s no shortage of other return-insensitive buyers for debt of a profligate government, starting with Japan ($1.3TN) and China ($1TN).

Interest rates are the transmission mechanism by which lenders receive compensation for inflation. In a world of negative real yields, perhaps the economy can tolerate some inflation.

The buoyant stock market is another financial market indicator that current and expected inflation aren’t creating any big problems. Quarterly earnings show that many companies seem able to pass through higher costs to their customers.

There are numerous signs that the jobs market is strong, with September job openings of 10.4 million just below August’s record of 10.6 million. Workers are increasingly willing to quit for a better job, and companies routinely complain of difficulties hiring enough qualified workers.

Unusually, inflation has become a political problem before becoming a markets problem. More common, for those of us old enough to remember tightening cycles, is for bond yields to rise, compensating investors for the risk of higher inflation and pressuring stocks. The administration, usually subtly, pushes back.

Today talk of inflation is everywhere, but anyone invested in stocks is still ahead of the game. For my part, stopping at a gas station has become a cause for unseemly celebration as I happily fork over an extra $40 while smiling at the bull market in pipeline stocks.

Borrowers are also benefiting from continued low rates.

The point is, today’s inflation is not an economic problem but a political one. Raising rates so as to drive up the unemployment rate won’t produce more truck drivers and will only appease the talking heads who are the visible pressure for action. An FOMC that has willingly monetized debt, synchronized easy policy with enormous fiscal stimulus and promoted a housing bubble doesn’t look like a group to willingly cause economic damage by hiking rates precipitously.

The FOMC will likely move slowly, because there’s plenty of justification for doing so. However, vice-chair Richard Clarida suggested on Friday a speedier tapering, which would allow faster tightening in line with current market prices. We think the FOMC’s dovish tendencies will incline them to move slowly – the market is priced for a more aggressive response.

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

Energy Mutual Fund Energy ETF Real Assets Fund

Please see important Legal Disclosures.

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:

Energy Mutual Fund Energy ETF Real Assets Fund

Please see important Legal Disclosures.