The Fed brings a new twist
And so does Delta
It is fair to say that last week’s FOMC meeting has been stressful for market watchers. This is not only because the Fed, ever so slightly, raised a warning finger against inflation, but also due to some rather odd market reactions.
But the volatility has had little impact. Since the minutes were released last week, movements in major markets have been microscopic. As of yesterday, the S&P 500 was up a whopping 0.01% and the 10 year Treasury yield was down an earth-shaking 0.03%. The VIX journeyed from 17 to 21, only to settle back at about 17.
Did we dig through a mountain, only to find a mouse? Is there more to this? Let’s see.
Before the meeting, there was a pervasive feeling of dread that the Fed was way behind the curve on inflation. The prints were getting hotter and it seemed that both the Treasury and the Fed were playing down the threat. Bloggers, tweeters, analysts, Larry Summers, Bill Dudleys - everyone looked to the Fed to validate their warnings.
So, the Fed threw them a bone.
Chairman Powell admitted that inflation was stronger than expected and rates will likely be raised in 2023. The dot plot even showed 7 out of 18 members open to raising rates as early as next year. But Powell hastened to add that he will continue to buy bonds at the existing rate of $120 billion per month. And just in case anyone got the wrong idea, he played down the tapering issue: the FOMC will only begin to “talk about talking about” tapering(!)
Thus the harshness of rate hikes was smoothed over with a lullaby of rustling cash. The net effect is beneficial.
First, by acknowledging higher-than-expected inflation and allowing for faster rate hikes, the Fed drained away tail risks that it would be left behind the curve. We need no longer be haunted by the ghost of 1994 whence the Fed slept while inflation went awry and rates had to be raised in panic mode, causing a market rout. That is off the table now. Instead, if inflation continues to surprise, the time table for rate hikes will move forward gradually, hopefully a softer landing.
Second, the Fed saved the stock market by continuing bond purchases. No doubt short-term (2-year) rates went up, but the Fed was able to keep a grip on 10 year rates. Why was this twist to the yield curve important? Well, here’s the thing. In a “bad inflation” environment, equities, especially technology, dislike rises in long-term rates more than in short rates. Some recent correlations:
Ever since inflation fears began to rise in mid-April, equities have become considerably more sensitive to the long-end of the yield curve. By the week prior to the Fed minutes, there was already a -50% correlation between 10 year rates and the S&P 500’s technology basket. That is among the most negative it has been in recent years.
Keeping 10 year yields stable allowed the Fed to show its hand on inflation without precipitating a correction in America’s most valuable sector. In fact, the Nasdaq is up about 2% since the FOMC minutes were released. The S&P 500 is unchanged which means that the non-technology sectors are slightly down.
This is a good strategy for the Fed and I don’t see why it cannot be deployed again if inflation prints keep heating up. Critics may say that the Fed cannot (should not?) do that because bond purchases may themselves be fueling inflation. I beg to disagree. Bond purchases certainly do cause inflation in financial assets but not so much in the basket of goods that comprises the Consumer Price Index (CPI). The many years of high QE and low consumer inflation testify to that.
Having said that, mortgage bond purchases can cause inflation indirectly through the housing market. The Fed is buying MBS at $40 billion a month (out of the $120 billion total) which keeps mortgage rates artificially low, fueling higher home prices. This pushes up rents which are a substantial share of CPI. But there is still some slack in the rental market, with many renters having locked in promotional deals during the pandemic. Also, home listing prices are cooling down as per Redfin. Overall, risks via housing inflation seem low.
The other criticism of bond purchases is that they fuel asset price bubbles which may burst uncontrollably, bringing down markets as a whole. To this point, I would say that the most recent bursting of the crypto bubble is helpful to the Fed. Cryptocurrency asset values have declined 50% or so without contagion spreading to traditional markets. Since this was the most obvious speculative bubble, and it is shrinking fast, it gives the Fed room to argue that (a) the bubbles are not too dangerous and (b) there is space for more easing.
Where does inflation go from here? Well, the Fed’s moves cannot influence the current demand and supply situation for commodities. Thus, to the extent that inflation is driven by commodity prices, it is not so susceptible to threats of rate hikes1. There is one important caveat, and that is the US Dollar. If the Fed gets more hawkish, we can expect the short end of the yield curve to go up further and that will mean a stronger US Dollar - a headwind for commodity prices. In fact, in the past week, the USD has gone up and prices of most commodities have declined. The decline does seem excessive and my speculation is that this is due to industrial metals being recently over-leveraged on the dollar. There is even a school of thought that this is a buying opportunity for commodities.
I am not against that thinking at least for some commodities where the demand pull is very strong or the supply is inelastic. Oil, Copper, Aluminum and Semiconductors come to mind.
The inflation fire can keep burning due to two other factors: President Biden’s stimulus plans and the Delta variant of the coronavirus.
The stimulus is facing opposition but I still expect that something big will pass by the fall of this year. By its very nature, Biden’s stimulus is likely to contribute to the pocketbook of lower income households which is inflationary in itself. Firstly, the savings rates are low (or negative) in that demographic and secondly their consumption tends to be commodity heavy. I would also add that a large “hard infrastructure” component to the stimulus will be another tailwind for commodities.
This brings us to Delta and labor supply. We know that a significant fraction of the population is still hesitant or unable to go back to work due to remote-schooling and fears of covid-19. Vaccine hesitancy has brought vaccination rates down to a snail’s pace - we will not hit 70% of adults vaccinated by July 4.
All this creates an opening for the Delta variant to further disrupt labor supply.
Delta is more contagious and has shown greater ability than the alpha (B.1.1.7) variant to cause disease in vaccinated individuals. It is also rising rapidly in the US with prevalence between 20-40% depending on who you ask. As per a Financial Times analysis:
Official estimates from the US Centers for Disease Control and Prevention put Delta’s prevalence at 10 per cent during the period from May 22 to June 5. The FT’s analysis applies similar methods to more up-to-date data, matching the CDC’s figure for late May but then rising rapidly to between 37 per cent and 42 per cent on June 20.
The variant is already causing exponential case growth in some states with low vaccination rates:
It is likely that within a month or so the US will not be in as secure a place as it is now. Anyone not working due to covid concerns will have an even better reason to stay home.
This will reduce labor supply but I expect demand for goods and services will not change much, at least until Delta really gets going in the US. There are enough vaccinated (and unvaccinated-but-don’t-care) people around and holiday plans are very much in place. Therefore, in the immediate term, I’d expect Delta to contribute to wage inflation and place pressure on growth i.e. stagflation. As a Delta wave progresses however, we could see material impacts on demand.
If commodity inflation also keeps moving along in some key sectors, then inflation prints will stay hot in June and July. Meanwhile, the bond market would keep moving its inflation expectations forward, in anticipation of the Fed. One can expect this will be more orderly though which reduces some of the risks for equities. Furthermore the Fed is unlikely to flirt substantially with tapering as they would want to keep financial asset markets steady.
As we enter July, it does appear that several powerful forces are going to battle it out in the hottest month. Inflation, the Fed, consumer demand and Delta.
Get my newsletter in your inbox every week.
Please read important disclaimers here. Your use of these materials is subject to the terms of these disclaimers.
Commodities are susceptible to actual rate hikes. Just not so much to threats of hikes.