The Fed and Inflation

From our April 2, 2021 issue of On Our Radar

For more than eight years (2012 – 2020) inflation was running below the Fed’s target of 2 percent. When asked about below-target inflation, the Fed’s response was the same; it was “transitory.” Consider the following:

“Inflation has been running below the Committee’s longer-run objective of 2 percent for some time and has been a bit softer recently. The Committee believes that the recent softness partly reflects transitory factors.” Chair Ben Bernanke June 19, 2013.

“As these transitory influences fade…the Committee expects inflation to rise to 2 percent over the medium term.” Chair Janet Yellen December 16, 2016.

“Core inflation stood at 1.6 percent for the previous 12 months. We suspect some transitory factors.” Chair Jerome Powell May 1, 2019.

However, after years of believing in their inflation theory and disregarding actual evidence, the Fed officially changed its monetary policy in September 2020 to address the below-target inflation. In fact, the Fed adopted flexible average inflation targeting. Since then, interest rates on the 10-year U.S. Treasury Note have more than tripled to approximately 1.7 percent.

What is interesting is that the median inflation projection of the FOMC participants is 2.4 percent in 2021, well above the current yield on longer-term U.S. Treasury securities. While it’s possible that the Fed is right and any inflation above 2 percent will be temporary – the 10-year inflation indexed security is still negative as seen below – it is also possible that the bond and stock markets may be tested by the highest level of inflation in many years.

This is something we are watching closely.

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It was one year ago that the global economy and financial markets were devastated by the onset of the COVID-19 pandemic. Coordinated responses by global central banks and governments flooded the markets with numerous liquidity programs in an attempt to offset the impact of forced lockdowns. Meanwhile, researchers and pharmaceutical companies went to work to develop a vaccine, which they did in record time.

While economies around the globe continue to gradually reopen, the markets have seen a tug- of-war of late as money has shifted from COVID beneficiaries – work from home, school from home, e-commerce, etc. – to those industries hit hardest from the shutdown, primarily the travel and leisure sectors due to social distancing.

The first quarter saw materially higher interest rates on the 10-year U.S. Treasury Note, higher oil prices, a blow-up in at least 2 hedge funds (1 a ‘family office”), and a ten percent correction in the NASDAQ Composite. Nevertheless, the S&P 500 index went on to record another record high.

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The S&P 500 index gained 2.6 percent in February even though the markets became increasingly volatile over the last week of the month as interest rates on the 10-year U.S. Treasury Note rose to the highest level in more than a year.  As vaccine rollouts have increased, the equity markets have seen a rotation out of a number of COVID-lockdown “winners” into those areas hardest hit such as energy, travel, and leisure companies that stand to benefit from the re-opening of the economy.

The 10-year Treasury yield rose to 1.44 percent at the end of February from 0.93 percent at year-end and a low of 0.52 percent in August 2020 as seen in the following chart.  While interest rates are still quite low on a relative basis, the rate of change has been significant as the yield has nearly tripled in about 6 months.  To put that move into context, the price decline on the 10-year Treasury is equivalent to roughly seven years’ worth of interest income.  

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January 2021 had a lot of drama, both politically and in the financial markets, with events that may have repercussions for some time.  On January 5th, the state of Georgia had two Senate runoff elections which gave the Democrats and Republicans a 50-50 split, with the tiebreaker going to Vice-President Kamala Harris.  The next day there was a clash at the Capitol Building as the Electoral College was in the process of certifying the Presidential election.  As a result, the House of Representatives issued an Article of Impeachment against former President Donald Trump. 

Later in the month the markets came under pressure due to intense “short squeezes” in a number of heavily “shorted” stocks – issues that were sold in the hope of buying them back at a lower price.  As you will see later, the substantial movement in a few stocks caused leverage in some hedge funds to be reduced, thereby putting pressure on the major averages.  As a result, the S&P 500 index fell 1.1 percent for the month after registering another record high.

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As we close the chapter on calendar year 2020, it is one that will not soon be forgotten.  2020 was unprecedented in so many ways due to the global pandemic that will likely impact the way we work, learn, socialize, and entertain for quite some time. 

The year began with President Trump ordering a drone strike on an Iranian security commander, which was then followed by the onslaught of COVID-19, government-mandated shutdowns, a recession, market turmoil, unprecedented monetary and fiscal responses, a recovery, an election, new vaccines, and an S&P 500 index that gained 16.25 percent for the year. 

At one point during the year oil futures traded in negative territory, and the yield on the 10-year U.S Treasury Note fell from 1.92 percent at the beginning of 2020 to a low of 0.52 percent in August before ending the year at 0.93 percent.

Drastic times called for drastic measures, and the White House, Congress, and the Federal Reserve stepped up in ways never before seen.  And given the ongoing uncertainty regarding the so-called second wave of COVID, they are not done.  President Trump signed a $900 billion COVID-relief package, which included funding the government through September 2021.

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Tim McFadden, Managing Partner at TJT Capital Group, contributed to a Morningstar Magazine article about Jim Callinan of Osterweis Capital Management. The article highlights one of TJT’s core principles: investing more money in uniquely positioned companies in growing industries.

Click HERE to read the article.

Following a 5.6 percent decline in the last week of October, the S&P 500 index rallied by an impressive 10.75 percent in November as some “worst case scenarios” regarding the election did not materialize. For example, fears of a contested presidential election reportedly caused some cities to board up windows as concerns about possible riots mounted. Given how contentious the atmosphere was heading into the election, a number of investors raised cash or “hedged” portfolios. Clearly, some of those hedges have been unwound over the past few weeks.

Some of the biggest rallies were seen in laggards such as energy and financial sectors.

In addition to the election, there were also worries about the rise in the number of COVID-19 cases as well as further restrictions on activity by some states. Moreover, Congress and the White House could not agree on the next round of coronavirus stimulus.

Adding to the post-election rally was positive COVID-vaccine news from Pfizer (BioNTech) and Moderna citing efficacy rates above 90 percent. While it will take several quarters to ramp production of the vaccines, if approved, investors are looking ahead to a better 2021.

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The S&P 500 index fell 2.7 percent in October on mounting tensions around the election outcome, a rise in the number of COVID-19 cases, and a complete stall in the next round of Congressional stimulus (CARES Act II).  Clearly, politics is front and center, and likely will be until a clear winner emerges.

Interest rates on the 10-year U.S. Treasury Note rose from 0.69 percent at the end of September to 0.88 on October 30, 2020.  Meanwhile, the price of a barrel of oil (West Texas Intermediate) fell from over $40 to about $35 in a month due to the continued decline in demand.

The initial CARES Act provided much needed support to households and businesses as a result of forced shutdowns, which included expanded unemployment insurance benefits.  The enhanced federal unemployment payment of $600 a week ended on July 31, 2020, although some state benefits extend until year-end.

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The S&P 500 index fell 3.9 percent in September and experienced the first ten percent correction – from the month’s intraday high to the intraday low – since the rally began in late March. Despite the decline, the S&P 500 gained 8.4 percent in the third quarter as economic momentum picked up, the Federal Reserve flooded the markets with liquidity, and the CARES Act (Coronavirus Aid, Relief, and Economic Security Act) provided much needed stimulus.

However, the markets fell under pressure due to a host of issues including the slow progress on the second round of COVID relief, the looming presidential election, the death of Supreme Court Justice Ruth Bader Ginsburg and the expected political battle over filling her seat, and fear of a second wave of coronavirus shutdowns.

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