FOMC, Commodity Inflation & Rates Update
June 23, 2021 | Cameron Parkhurst
As we pass the Summer Solstice of the 2021 calendar year, the temperature is not the only thing heating up. We have had a consistent theme for some time now regarding inflation, and we have seen a sharp rise in commodity prices, indicating that an inflationary effect likely will be a factor looking forward. We have also been eagerly awaiting output from the FOMC meeting and have been having much internal banter about the recent calmness in the fixed income markets, especially with the commodity inflation backdrop. Thus, we want to unpack these three themes a bit and tie them together in a thesis that helps lead us to our current portfolio construction objectives.
First, The Fed. Fed Chair Jay Powell highlighted the FOMC views of a post-Covid pandemic recovery and indicated that they could likely accelerate the time frame on taking their foot off the gas. Although he indicated that the Fed would continue asset purchases for now, there was also some discussion of forward thinking around the tapering of asset purchases in the future.
As to the employment picture, The Fed seems to have a 5% long-term average target on employment and is focused on not taking major action until this threshold is reached. For many analysts, including us, this paints a perplexing issue. Please see the charts
With all the stimulus money floating around, including unemployment benefits and post pandemic action (such as re-attending college, caring for elderly parents and/or avoiding childcare costs by one parent staying home),there is a dynamic of many people effectively leaving the potential employment base. Labor force participation rate is near an all-time low. At the same time, many companies are itching to hire qualified candidates and having a tough time doing so. Our hypothesis is that this could lead to a rebound soon of some former participants in re-engaging the job search, while quickly securing employment. Could this drive the unemployment rate into that 5% threshold prematurely? When evaluating the Natural Rate of Unemployment, NAIRU, the Fed seems to be targeting 4.5% for this year, 3.8% for 2022 and 3.5% for 2023 (with a long run 4.0%bogey). The jury is still out, but we believe that we could see this with current dynamics in place. With this in mind, and with a robust economy including commodity inflation, we think that there is a case to be made to see a combination of tapering and even Fed Funds movement in2022.As the Fed says, a lot of this is very data dependent.
Looking at the Federal Reserve balance sheet, if tapering were to occur, it seems like there would be an unwinding of corporates and MBS first (they are doing a small test trial of MBS sales next week). This could be the canary in the coal mine, highlighting potential accelerated future Fed tapering action for starters:
Second, we have a dilemma. Headline CPI rose 5% year over year for May 2021.Looking at it month over month, it rose 0.6% versus consensus expectations of 0.5%. Core CPI, which excludes food and energy prices, rose 0.7% month over month versus consensus expectations of 0.5%.This represents the largest CPI gain since August 2008:
The dilemma revolves around how the bond market has reacted to the inflationary numbers, and more importantly the food fight as to who is going to be right historically speaking.
Historically, the bond market has been more right than wrong. If you evaluate the chart above, the bond market is either totally shrugging off the inflation numbers, or there is a supply/demand imbalance. Rates have literally not moved recently while commodity prices have soared. The hawkish Fed-speak brought some commodities back to reality this week, but in general, most commodities are showing inflation. If there is inflation, why are bond yields not moving, and even heading lower post-Fed meeting?
First, the inflationary pressures seem segmented and, in many cases, transitory. For example, used car process, up 7.3%, significantly skews the numbers. Apparel and transportation prices, airlines included, are up significantly. Is much of this simply people getting ready to go back to work and/or feeling the urge to get out, take that vacation, etc.? If that is the case, things will normalize.
Some analysts are indicating that the lack of upward pressure on bond yields is due to factors such as fear over COV-19 variants reshuffling the deck re: lockdowns (as we have seen worldwide, not so much in the US), and significant demand vs. more limited supply. There continues to be a lot of foreign demand for our domestic Treasury market. Crazy to think about a 1.50% 10-Year being high yield, but our US Treasury market is really that when compared to Europe or Japan, for example.
We believe that the bond market is being relatively rational as usual, and that the yield drop in the 10-year Treasury last week reflects a combination demand outweighing supply, Fed-speak anchoring rates for the time being, and general post-pandemic recovery strength.
One important point to note is the flattening that has been seen post meeting. The 30- Year Treasury came in 15 basis points Thursday, which is the largest move since early 2021. The Fed, in discussing acceleration of their taper/Fed Funds rate timeline, has brought front end rates up a few notches and long rates down, as it could have an impact on longer term inflation results. With greater credibility about fighting potential inflation, some have bought duration, thus closing the gap between 5-year and 30-year Treasuries, for example:
As this impacts our portfolios and the markets that we follow, not much has changed for the asset allocators. We are still evaluating relative value strategies for our clients. Taxable municipals still provide the bulk of the value add in taxable portfolios, followed by select corporates. We really do not see much value in CDs and most Agencies, currently. Some MBS can make sense if clients are ok with possible future extension risk. Tax free municipals have caught quite a bid and are seemingly rich. Even with that said, for higher tax bracket clients, we continue to bid and win bonds for laddered portfolios. We continue to favor higher credit where possible and are certainly not making a major bet on duration. Laddered portfolios do well in a slightly inflationary environment, as we reinvest maturing principal at higher rates.
As always, we are here to help you in any way regarding your portfolios. Please do not hesitate to reach out with any questions, comments or to set up a short discussion.
Until Next Time,
Your PeachCap Fixed Income Team
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