We've been writing for some time now about how inflation was going to ramp higher and faster than most were anticipating as the economy reaccelerated out of the pandemic-induced recession. Our original post in August of '20 laid out the foundation and argument for a new inflation paradigm, and the last years', and few months' in particular, inflation data has corroborated this view. Last weeks' inflation data came in hotter than expected at 7.5% year-over-year for January, vs. 7.2% consensus estimates. It seems that many market participants, including the Federal Reserve, are playing catch-up.
We discuss in this episode of The Wealth Effect Podcast:
💸 Consumer Price Index Inflation
📉 Yield Curve Inversion
📈Inflation Fighting Beneficiaries
Matt Faubion, CFP®
Founder - Wealth Manager
Show notes and charts:
Interest rates across the entire yield curve have run up rapidly in the face of higher inflation, and the market is now pricing in Fed lift-off (rising short-term interest rates) to the tune of 6 quarter-percent rate hikes by year-end. From stocks to cryptocurrencies, risk-assets have been struggling to digest this dynamic and remain in correction mode off of their recent all-time highs.
1) Inflation Ramped to 7.5% In January, Above Estimates of 7.2%
Consumer Price Index (CPI) and Core CPI (Ex Food & Energy)
With Fed Funds futures anticipating 6 rate hikes by year-end, the 1-year forward yield curve (the markets estimate for interest rates one year in the future) is pricing in a yield-curve inversion. This is a dynamic where short-term interest rates are higher than long-term interest rates and is one of the strongest indicators of an impending recession. This, however, would be entirely controlled by the Federal Reserve interest rate policy - and would be a significant policy mistake, almost locking in an economic contraction, if they were to do so.
2) The Market Is Pricing In A Yield Curve Inversion Next Year
1-Year Forward 10-Yr Minus 2-Yr Treasury Bond Spread
Unfortunately, long-term inflation appears to have many of the necessary ingredients to remain sticky and prevalent. Broad-based wage gains coupled with low unemployment, supply-chain disruptions and re-shoring, high home and rental prices, a massive increase in the money supply over the last 24 months, and high and rising inflation expectations all point to lasting inflation dynamics within the economy. As a result, inflation-fighting assets such as gold, oil, and commodities are benefiting.
3) Commodities Continue To Appreciate
Prices of oil, corn, copper, and lumber
All of this is important because if the Fed follows the path of rate increases the market is anticipating, it is likely to be a path of tightening too quickly into an economic slowdown and would prove to be a policy mistake. This is a decently probable outcome that investors should be aware of. However, it is also likely that sentiment for inflation has reached its local zenith. With the impending inflation inflection, inflation will begin to wane as new data arrives, showing a meaningful reprieve in general price growth. This would likely reduce interest rate expectations, reduce Fed action, increase financial conditions, and be positive for the economy as a whole - though it would lock in the seeds mentioned above of longer-term inflation.
The Bottom Line: Market inflation and interest rate expectations are most likely in the process of peaking, and an inflection in the opposite direction is probably. However, the path of Federal Reserve policy is uncertain, and future economic outcomes are primarily Fed path-dependent at this stage in the economic cycle. For investors, being balanced, diversified, and positioned for a wide range of economic outcomes becomes ever more important to stay invested through the current uncertainty and volatility.
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