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‘Has the Fed just killed the cycle?’

Despite currently very high headline rates of inflation -  CPI of 5.0 % and PPI of 6.6% - the US Treasury yield curve has been flattening since March 31st when the 10-year peaked at 1.74%, the bond market already endorsing Fed Chairman Powell’s view of inflationary pressures as largely “transitory”.

Strange then, that in an apparent change of message the recent FOMC decided that inflationary pressures might not necessarily be transitory after all and was already discussing tapering asset purchases, with the average Fed member also bringing forward their expectation of the first interest rate rise.

The Fed had previously communicated that it was relaxed about a robust economic recovery resulting in a period of above 2% average target inflation: that 2% was a “medium term” average not a ceiling that forced the Fed to act. Just as no one really knows how much current inflation is really “transitory”, confusion exists over the “medium term” definition and whether it is backward or forward looking?

This hawkish messaging may have been more understandable had it been given three months ago when many worried that the Treasury  yield curve was steepening too quickly and the Fed was losing control of long-term interest rates; when commodity prices were almost daily hitting new highs; now it seemed clumsy, resulting in fears that the Fed would kill the cycle with a monetary policy error.  As a result, the Fed’s hawkish pivot resulted in long-term interest rates - and inflation expectations - falling further.

It is a puzzling conundrum that the Treasury yield curve is now flatter than pre-COVID: there is plentiful evidence of current rampant inflation; central bank asset purchases over the past year have been of the same quantum as over the whole of the last decade; perhaps more importantly, we have witnessed the decisive end of fiscal austerity, with the Biden administration expected on average to run a double-digit deficit for its entire term. It does not make a lot of sense for the bond market to currently price a LESS inflationary long-term future.

The Fed’s dual mandate of price stability and full employment also seems to have recently expanded to a third goal of fighting “inequality”, recognising the limited real wage growth amongst blue-collar workers over the past decade. What this means in practice is that the economy needs to be run “hot”, with shortages of labour leading to sustainable wage hikes. Fighting “inflation” and “inequality” is therefore somewhat incompatible: at some point the Fed will be forced to choose. Killing the expansionary economic cycle would hurt blue collar workers hardest.

The US government bond market has become the predominant influence over equity style risk: when the Treasury yield curve steepens, more cyclical reflationary “Value” stocks outperform; when it flattens the equity market worries about the duration of the cycle, leading to a resumption of the 12-year deflationary equity “Growth” stock bull market. Whilst we think we are equity investors it turns out we have really been trading bonds, specifically the Treasury yield curve.

There is no certainty over what happens next. We should consider that the current Fed leadership have previously warned of the historic “mistake” of withdrawing stimulus too quickly and killing the reflationary cycle. The flattening Treasury yield curve is already a visible warning of this policy error risk. Emboldened by their new political “Triple” mandate we might expect the Fed to talk-the-talk on “inflation” but walk-the-walk on “inequality”, with the perceived risk of being “behind the curve” on inflation a healthier steeper yield curve.

From what we have recently witnessed with equity style risk and bond correlations, whether the Q2 rotation back to “Growth” stocks is symbolic of “end of cycle” or a buying opportunity in “Value” equity depends on whether the current 1.5% yield on a 10-year Treasury represents a good long-term investment? If the 10-year yield ends 2021 at 2% then it is likely that more cyclical value stocks will have performed well, given the greater confidence this implies in the duration of the current economic expansion.

Many investors have also forgotten the capital cycle: that although we have just witnessed a particularly innovative decade of economic growth, investors always end up over-allocating capital to glamorous industries; where -  as the cycle becomes long in the tooth - it becomes easier for  average or even fake business models to raise capital at stunning valuations. When stocks become a sellers’ market, it is normally time for a healthy dose of scepticism.

We can contrast this with modestly priced equity in currently booming cyclical industries such as homebuilding, mining, steel, agriculture, transportation, and semi-conductors where the market seems currently overly cautious on the duration of the cycle. Whilst it is obvious that current trading amongst cyclicals will lose some momentum when inventory re-stocking is complete, the crucial debate is whether it will be a soft or a hard landing, with the former more consistent with the expressed desired outcomes of the Fed, but the market currently pricing the later.

Barry Norris
Argonaut Capital
July 2021