Fed chair Jay Powell wasn’t to blame for Thursday’s equity market sell-off, no matter what journalists thought. His comments were dovish, reaffirming the Fed’s desire to see meaningful improvement in employment before moderating their bond buying. Tightening is nowhere in sight. Had he said the opposite, markets would have probably fallen further, which simply means bonds are in a bear market.

Powell’s comment that he would only be concerned about bond weakness if it led to tighter financial conditions suggested that the Fed would be inclined to counter such a development, perhaps by increasing their own bond purchases. He expects any increase in inflation to be temporary. Fixed income investors aren’t so sanguine and are demanding fair compensation for increased risk. To own bonds at current yields requires a faith in the Fed’s forecasting ability not supported by their track record. They have no insight that isn’t found in many private sector forecasts; but they do have the power to act.

The Fed’s beige book provided a mildly encouraging outlook, but mentioned the word “shortage” 31 times, the most in a decade. It applied to difficulties in filling many different job types, petrochemicals and chips used in automobiles. CNBC reported that raw materials costs for a new car had risen $1,152 in the past year. Today’s Fed cares more about unemployment than adequate returns to bond buyers. It’s correct and democratic, but translates into inadequate interest rates.

We were also surprised to see evidence of very strong new business formation. Thanks to Barry Knapp of Ironsides Macroeconomics for pointing out the surge in IRS issuance of Employer Identification Numbers (EINs), one of the first steps in launching a new business.

Stocks are attractive but, in some sectors, vulnerable to higher rates. This is most apparent among growth sectors such as technology, which has been supported by low rates for years. Ten year treasuries at 2%, 0.5% higher than now, still wouldn’t make bonds a buy. But because the net present value of a growth stock is more reliant on distant cashflows than is the case for the overall market, rising rates hurt more. If you think of a growth stock as analogous to a zero-coupon bond (returns backloaded) and compare it with a similar maturity coupon-bearing security, you’ll appreciate that growth stocks have greater interest rate sensitivity (duration), just like a zero-coupon bond.

OPEC’s decision not to increase supply for now gave a further boost to the energy sector. Pipelines are providing useful protection against rising rates, since both are going up with the reflation trade. After several years of negativity, it’s a long way from a crowded trade. We expect Free Cash Flow (FCF) to continue growing this year, such that pipelines will offer a FCF yield of 10% by year’s end; double the S&P500. The American Energy Independence Index (AEITR) is now back above its pre-Covid 2019 year-end level, and is narrowing the performance gap with the S&P500.

Exxon Mobil (XOM) has doubled in price since October. Its dividend, increasingly secure as crude rallies, still yields over 6%. It’s hard to see a strong bearish case even following such a strong rally.

The strength in energy has coincided with weakness in solar stocks. The Invesco Solar ETF (TAN) is –7% YTD, versus the AEITR which is +20%. Over the past year, solar stocks have outperformed significantly, but as growth stocks they’re vulnerable to rising rates.

Maybe solar investors have considered the two maps showing the global disposition of coal-burning power plants, which vividly portrays where the world’s increased CO2 emissions will be coming from. Developing countries, many of them in Asia, will be adding significant power capacity reliant on coal. Increasing global trade in natural gas is preventing this damaging development from being even worse.

The hype around renewables makes it seem as if America can singlehandedly save the planet if we’d just shift to 100% solar and wind. New York’s mayor Bill de Blasio wants to ban natural gas hookups for new buildings by the end of the decade. If you’ve visited New York recently you may conclude that de Blasio’s chronic mismanagement is curbing the need for much new construction anyway. But he epitomizes the simplistic view that is oblivious to what’s actually happening.

The world’s going to use more of all kinds of energy in the next several decades, as economic growth in emerging economies drives up demand. We’ll use more renewables, natural gas and, unfortunately, more coal. Unless we can flip those dots, each of which represents a new source of coal-based emissions, to something cleaner (natural gas is the obvious choice), we’d better plan on living with more CO2.

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

“At this point, the Federal Open Market Committee is seeking inflation running moderately above 2% for some time.” Fed chair Jay Powell, Senate testimony February 23.

The Fed is walking a fine line, and it’s easy to take this comment out of context. Inflation can be too low, and in order to ensure they adhere to their dual mandate of maximum employment consistent with stable prices, the Fed is willing to take a little risk with price stability. Nonetheless, if the marble hallways of the Federal Reserve building in Washington DC display carved quotes from Powell’s predecessors, this one is unlikely to be added.

The Democrats have embraced Modern Monetary Theory (MMT) in all but name (see Democrats Will Test The Limits On Spending). The only theoretical limit on government spending is when it’s inflationary, and until it is one must conclude spending plans weren’t bold enough. Today’s low bond yields are a piggybank to be raided for Covid relief, infrastructure spending and the energy transition.

Fixed income investors have been abused by paltry yields for years. The biggest question in finance today is why long-term rates have remained so persistently low for so long. Real yields have been falling for at least a generation. Inflexible investment mandates for institutional investors such as pension funds, which mandate a fixed income allocation regardless of return prospects, are part of the reason.

Bond investors’ passive acceptance of diminished returns has made Democrat spending plans possible. $2.8TN in the Fed’s expansion of its balance sheet, $3.4TN in deficit-financed spending, plus the latest $1.9TN Covid relief plan add up to over $8TN in stimulus.  As Barry Knapp of Ironsides Macroeconomics notes, this is to offset the estimated $1.1TN nominal GDP output gap caused by the recession. In other words, we’re plugging the economy’s hole by a factor of over 7X. There’s little risk that the government’s financial response to Covid could be criticized as inadequate.

Against such a backdrop, even though Powell was simply repeating past comments on desiring higher inflation, it did betray a lack of sensitivity to bond investors still contemplating the 7X noted above. Under these circumstances, when the Fed wants inflation above 2% “for some time,” why would a return-oriented investor hold ten year U.S. treasuries yielding only 1.5%?

Inflation expectations have been drifting higher, recently breaching 2% for the first time in two years. Powell noted that, “… forecasters need to be humble and have a great deal to be humble about frankly.” Such humility must be abundant at the Fed, whose forecasts of short-term interest rates published in their projection materials were too high for most of the past decade (see Bond Market Looks Past Fed).

The bond market’s forecast of the “neutral”, or longer run Fed funds rate was consistently lower than in FOMC projections for years. The Fed steadily followed the market’s forecast lower. Predicting interest rates is hard. The Fed’s not very good at it. But their persistent failure to correctly forecast a rate that they set is amusing, for those who follow such things.

Now the situation is reversed; fixed income markets are beginning to price in higher short term rates by late next year, whereas the FOMC expects to keep rates low at least through 2023.

It’s unwise to bet against the Fed. But with $8TN of stimulus going up against the FOMC’s forecasting record, it’s likely that the Fed’s reputation will remain intact.

Inflation may not rise at all, in which case the bond market’s hissy fit will have been just that. However, Powell expects it to rise later this year before falling, which will be far more interesting.  The period of time during which inflation is above target may seem interminably long for investors positioned for it to be temporary. Bond yields will reflect how closely investors share the Fed chair’s breezy confidence.

The eurodollar futures market reflected this change in expectations over the past week. Risks are more correctly priced in than before. However, there is no limit to the amount of stimulus that Washington will provide. If a Covid mutation creates a setback, the response will be predictable (see The Biden Put). Ten year treasury yields at 1.5% still don’t reflect that reality.

Rising rates aren’t necessarily bad for stocks, unless they move sharply.

For example, pipelines have performed well so far this year. The sector is more insulated than many to bond market risk – if rates do move substantially higher, it will be because demand for most things including energy is booming. Investors are beginning to recognize this, since the sector (as defined by the American Energy Independence Index, AEITR) has become a reflation trade, tracking bond yields higher.

Pipeline company dividend yields remain very attractive. Consider natural gas pipeline behemoth Williams Companies (WMB), whose equity yields almost 7%, a level still suggesting still some risk to the security of the payout.

Last week they announced they’ll be increasing it by 2.5% this year. Pipeline stocks still offer attractive upside.

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

Bill Gates readily concedes that the world isn’t short of “rich men with big ideas” in How To Avoid A Climate Disaster. He brings an intellectual honesty to the climate change debate that is absent from Democrat policy prescriptions, and often ignored by Republicans. Gates has done his homework, producing a book spilling over with facts and insights. The climate impact of each human activity (use of power, making things, moving around) is presented, along with its contribution to the 51 billion tons of Greenhouse Gases (GHGs) emitted annually. He presents the issues in an easily understood framework that many readers should find engaging and accessible.

Although Bill Gates is surely a Democrat, it’s unlikely progressives will welcome his contribution. He dismisses Democrat orthodoxy by showing that the energy transition will be very expensive. He feels we should be motivated by the moral obligation to counter planetary warming because it will harm poorer countries the most. Rich countries can afford to manage rising sea levels (see Netherlands).

Since the Gates Foundation is focused on disease and malnutrition in the developing world, his altruistic view isn’t surprising. And the moral argument is a respectable one. But it exposes the enormous political challenge in gaining popular support for higher domestic energy prices to stop, say, Bangladesh flooding. Last week Joe Biden rejected a French proposal to redirect 5% of our Covid vaccines to poorer countries until all Americans have been vaccinated. It was a minor acknowledgment of political reality. Few have the means or inclination to dedicate themselves to solving poor countries’ problems before their own.

How To Avert A Climate Disaster reaches positive conclusions because it argues that current technology and innovation make solutions within reach. It provides policy prescriptions but deliberately avoids the politics. In many cases Gates calculates a “green premium”, reflecting the cost of converting transport, power generation, cement or steel production to be emission-free. Not surprisingly he favors a carbon tax to create price signals that fully reflect the externalities of burning fossil fuels.

Renewables figure far less prominently than in the Green New Deal (see The Bovine Green Dream), a document Gates would likely view as fantasy if he didn’t studiously avoid such engagement. He illustrates the fundamental problem of solar and wind intermittency by considering the battery back-up a Tokyo 100% reliant on windmills would require to maintain power during a not-uncommon three-day typhoon. Even with optimistic assumptions about improved technology, the cost would be prohibitive. Gates concedes to have, “…lost more money on start-up battery companies than I ever imagined.” He knows a bit about the subject.

Although efforts to curb emissions around the world generate enormous energy and press coverage, any actual improvements to date have come mostly from coal-to-gas switching for power generation (i.e. the U.S.) or last year’s drop in global economic activity due to Covid. U.S. energy costs haven’t risen noticeably, although California’s energy policies have managed to combine high costs with unreliability (see California Dreamin’ of Reliable Power).

Gates believes poor countries should be allowed to increase emissions, since energy consumption is inextricably linked to improved economic well-being. “We can’t expect poor people to stay poor because too many rich countries emitted too many greenhouse gases” he argues from the lonely moral high ground.

Reaching zero emissions by 2050 requires western democracies imposing substantial new regulation and costs on economic activity for decades. Meanwhile, the world’s building stock will grow mostly in poorer countries, requiring cement, steel and all the other emission-producing byproducts of human advancement. This construction will add the equivalent of another New York City every month for decades.

Gates asserts that climate change will inevitably cost – inaction will lower GDP, and action will take lots of money. It’s well he doesn’t consider how governments will sell this to voters if an honest discussion ever occurs, because by comparison the technical challenges are more easily solved.

Recognizing the political impracticality, Joe Biden instead disingenuously talks about “…tackling climate change and creating good union jobs here” (his emphasis).

The technology already exists to capture the carbon dioxide emitted by burning fossil fuels, whether to generate electricity (27% of global GHGs) or produce steel (manufactures also including cement and plastics in total are 31% of GHGs).

Gates estimates that emission-free power in the U.S., to include gas and coal with carbon capture, would raise prices by 15%. The green premium to make ethylene (plastic), steel and cement without CO2 emissions would raise prices by around 12%, 23% and 110% respectively. We could already start implementing such policies if the support was there. But political leaders avoid such talk, recognizing that voters’ concern about climate change doesn’t include much tolerance for higher prices.

An energy investor today has to assess plausible outcomes, ignoring the shrill rhetoric of climate extremists unburdened by the costs, facts and technological challenges Gates lays out.

Emerging economies will continue to grow, feeding all the increase in global energy demand as they seek OECD living standards. Their GHG emissions will rise. How tolerant will western democracies be of rising costs for virtually everything while we save the planet and allow poorer countries to catch up?

Bill Gates is an unfailing optimist – invariably the most pleasant posture for living. But your blogger found the comprehensive list of what needs to be done dauntingly improbable. Mitigants of the results of global warming are probably a better investment than betting on decades of extended selflessness by 1.3 billion OECD citizens, the rich world whose collective actions Gates believes will save all 7.6 billion of us.

There are already bold options available. We could phase out coal. We could require carbon capture on industrial use of fossil fuels. We could use more nuclear, whose safety record per unit of power generated is unmatched. Instead, more solar and wind is the climate extremists’ mantra in spite of intermittency and the NIMBY challenges of building transmission lines to move power from sparsely populated solar and wind farms to population centers (see Review Of Russell Gold’s Superpower for an example of how hard this is).

Burning less coal, carbon capture and compensating for renewables’ unreliability all support growth in natural gas demand. Gates argues against a shift to natural gas for power generation. He fears the 30-year life of a typical combined cycle power plant would embed its CO2 emissions for too long. It would show progress to 2030, while putting zero by 2050 out of reach. But if tangible results within the timeframe of election cycles are needed, it’s hard to see a better way.

If in a decade that’s how things have turned out, Gates the pragmatic optimist will hail it as success. We should too.

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

Bill Gates, in an interview two years ago, asked how Tokyo would cope with a typhoon if it was fully powered by renewable energy. Compensating for the loss of solar and wind for two to three days would require enormous battery back-up that would sit mostly idle, other than once every few years. He noted the economics would be unworkable.

Texas is a leader in wind energy. It’s tempting to blame the recent blackouts prompted by exceptionally cold weather on the intermittency of wind power. A photo of a helicopter de-icing windmill blades  became an iconic reminder of the opportunistic nature of renewables. Widely circulated on social media, it turned out to be from Sweden several years ago.

Texas uniquely has its own power grid, overseen by the Electric Reliability Council Of Texas (ERCOT). Power suppliers compete to provide electricity to the network, and while free markets have much in their favor, reliable power in that market is clearly under-valued. Wholesale electricity prices reached $9,000 per MWh, the limit set by ERCOT. Average U.S. residential prices are 13 cents per KWh, equal to $130 per MWh. Some Texan households will be getting a shockingly high utility bill.

Wind power collapsed leading into the Presidents Day weekend. This wasn’t an unfortunate coincidence, but was a result of icy temperatures that caused power demand to spike. Rolling power cuts extended well beyond Texas, and some natural gas power plants also went offline because cold weather restricted their operations. Nonetheless, natural gas power generation soared when needed. It’s negatively correlated with wind power output, a valuable quality for portfolios of power generation as well as stocks.

The energy sector responded by continuing its strong rally. The American Energy Independence Index, which consists of North America’s biggest pipeline companies, is up 15% YTD, 10% ahead of the S&P500. This could simply be a response to rising oil and gas prices, but it may also reflect a growing awareness that the world will need all sources of energy for the foreseeable future. Solar and wind are prone to go offline during extreme weather events. California’s drive to expunge everything but solar and wind led to rolling blackouts last year during a heatwave (see California Dreamin’ of Reliable Power). Renewables are developing an unfortunate reputation for being there until demand surges, when they’re most needed. Providing back-up adds significant expense.

It’s too early to judge the public response to this failure. Texans are still trying to stay warm. But a cooling dose of realism poured on the single-minded focus on renewables is long overdue.

U.S. foreign policy is now configured to take account of our climate goals, which is a positive development. However, the charge of hypocrisy is easily leveled against both people and countries trying to persuade others to change their ways.

For example, the U.S. plans to halt funding for overseas fossil fuel projects, so as to highlight China’s continued bankrolling of coal projects among poorer countries. China is doing more to warm the planet than any other country – they burn half the world’s coal and are promoting its use among others. With poorer countries less able to cope with rising sea levels, we’re in the odd position of promoting behavior that we find more in their interests than they do. And while reduced coal use is a good objective, the U.S. is forecast to increase its coal consumption this year and next (see Emissions To Rise Under Democrats).

Past years switching from coal to natural gas are being reversed, because natural gas isn’t as cheap as it used to be. Democrat policies are designed to increase energy prices, with sometimes unintended consequences. American leadership would mean phasing out our own use of coal.

Moreover, Joe Biden’s emissary to convince the developing world to use less coal is John Kerry, whose lifetime of private jet travel must make his personal carbon footprint the envy of those he would persuade.  Climate change is a serious issue but is not yet receiving a coherent policy response.

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

Modern Monetary Theory (MMT) argues that because a government can never go bankrupt in its own currency, the only constraint on spending is inflation. Applied to the U.S., this justifies pandemic stimulus checks, spending on infrastructure and clean energy initiatives, expanded Obamacare and doubtless other initiatives too. Price tabs begin at $1TN nowadays. Stephanie Kelton’s book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy is worth reading to better understand where this theory will take us. We reviewed it last November.

There are no votes left in fiscal discipline, and investors don’t seem too worried either. With 30 year yields at 2%, there’s little evidence that voters should be more concerned than the bond market.

Kelton was an advisor to Bernie Sanders, now head of the Senate Budget Committee. We are embarked on MMT – although even Kelton’s advocacy of fiscal profligacy recognizes the inflationary constraints of the government outspending the economy’s ability to deliver goods and services. She quaintly believes Congress should score spending plans based on their potential to cause higher inflation, as if election cycles had ceased to exist. No such concern burdens Biden’s $1.9TN proposed Covid relief plan.

Betting on higher inflation, and rising rates, has been a losing proposition for over thirty years. It would seem foolish to expect anything different now – except that making such a bet is extraordinarily cheap.

The eurodollar curve, which reflects market expectations for three month Libor, is very flat. It’s true Fed chair Powell has said the Fed plans to keep rates low for a long time, and is willing to see inflation move above 2%, compensating for periods when it’s been stubbornly below their desired average. The futures curve takes him at his word.

But the stage is set for the market to test this view. The kindling includes unprecedented fiscal stimulus, almost $5TN in money market funds, up $1TN in a year (some of which is entering the stock market via Robin Hood) and a probable burst of pent-up consumption once pandemic lockdowns are eased. This may all be easily absorbed by the economy – but many are watching carefully, and a couple of high CPI figures will confirm the worriers.

Commodity prices have been rising. Energy companies are more cautious with their investment plans, which is going to constrain supply in the future. Pipeline opponents have made new construction prohibitive. Investors in the sector like higher energy prices and lower growth capex, so are finding the Democrat agenda surprisingly appealing. These are encouraging circumstances for midstream energy infrastructure, up 11% so far this year.

Bond yields are slowly rising to reflect inflation risks, but remain uninvestably low. Sovereign debt ceased offering real returns (i.e. above inflation) years ago. Those days may never come back – MMT advocates will eagerly grasp this vindication of their policies.

December 2022 eurodollar futures yield 0.30%, just 0.10% above today’s three month Libor with 22 months to go and reflecting equanimity about the possibility of higher rates over that time frame. A short position will lose roughly half a basis point per month — this is the cost of negative carry. If the market develops even the slightest fear that rates may rise, a 25 or 50 bps move in eurodollar futures is likely. The Fed probably will remain on hold – but there’s little to be made betting with them, and little cost in betting against.

Stocks remain modestly attractive, but that is dependent on bond yields. Factset 2021 and 2022 earnings forecasts for the S&P500 are moving steadily higher, albeit still not back to pre-pandemic levels. But 2021 forecast S&P500 EPS of $173 per share is nonetheless $10 ahead of pre-pandemic 2019. Covid has changed millions of lifestyles for the better and created big winners and losers among businesses, but history will show a one year dip in public company profits.

Energy companies dominate the list of 1Q21 upward revisions to earnings. The Equity Risk Premium (ERP), the difference between the S&P500 earnings yield and ten year treasuries, is supportive. However, if long term interest rates were to rise, say, 1% stocks would be less alluring.

The goal of MMT is to push the edge of the envelope. Both political parties have discovered that increased deficits carry no penalty. Now that we’ve informally adopted MMT, higher inflation one day is assured. We just don’t know when. But Federal government spending policies reflect an enthusiastic pursuit.

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