Fed Acknowledges Higher Inflation

This past Wednesday saw Fed Chair Jay Powell finally acknowledge what everyone has known for months, that inflation is running hotter than forecasted. He also said that Fed officials have started discussing tapering, that is gradually reducing their monthly purchase of $120 billion of Treasuries and mortgage-backed securities. While the tapering talk is a step in the right direction, the Fed isn’t about to reduce their purchases any time soon. As we have stated before, there is no reason the Fed should still be buying mortgage-backed securities with the housing market as hot as it is.

On the back of Jay Powell’s slightly more hawkish stance, St. Louis President James Bullard made comments Friday on CNBC that he expects the first rate hike to occur in late 2022, which is earlier than had been previously communicated. If the economy continues to be strong, it makes sense to not wait until 2023 to start raising rates.

On the investment front, it was a tough week for the “reflation trade” which, until the shift in the Fed’s thinking this week, had been leading markets higher. Reflation refers to an economic recovery where growth and inflation are accelerating. Reflation generally follows a recession where economic growth declines and deflation occurs. Here are some of the declines from this past week in the groups that make up the reflation trade:

Banks -6.93%
Energy -5.4%
Materials -6.25%
Small Cap Value -6.67%

Also declining for the week, Gold finished down 6.15% and Silver was down 7.69%.

Even before this week’s Fed meeting many commodities, as well as the share price of industrial companies, had begun to fall. The Fed meeting escalated the recent moves. In total, here are some of the declines from their recent highs:

Lumber -48%
Copper -16%
Caterpillar -15.3%
United Rentals -19%
Deere -18%

With the pullback in the reflation trade, the market seems to be saying that with the Fed more focused on inflation the probability of persistently higher inflation has decreased.

Another data point we are paying close attention to is the 10-year Breakeven Inflation Rate. This is the difference in the yield between a 10-year Treasury and a 10-year Inflation-Protected Security and it tells us what the market’s expectation of inflation is over the next 10 years. This peaked on May 17th at 2.54% and has since declined to 2.24%. Of course this spread could start to increase again, but it has been a welcome development to see it reverse after a big move higher over the last year.

In the financial markets summer may be known for vacations and lighter trading volume, but there hasn’t been a dull moment so far this summer. Like the weather, we believe the inflation data will continue to come in hot. What the market appears to believe is that inflation now has the Fed’s attention and thus is more likely to settle back near 2% over the next year. It won’t be a smooth path, but we are closely watching and will take advantage of opportunities that arise.