Jack Meskunas, Oppenheimer & Co
22 July 2021Asset management analysis

Inflation up, rates down?

Many captives owners and managers have asked me recently how and why what they are seeing “in the real world” and in the stock and bond market don’t seem to make sense—at least from a historical perspective. They note that there are signs of inflation everywhere—in the grocery store, the car dealerships and at the gas pumps. Wages are rising and the government is giving money away like Kewpie dolls at the state fair.

Normally under these circumstances (although there has never been exactly the same set of circumstances in the past) you would expect to see the bond market falling in value, rates rising, and the Fed stepping in and raising short term rates. The entire “yield curve” should be lifting to higher levels across the maturity spectrum. Yet the rate of interest on the 10-year benchmark Treasury Note has actually fallen during this time.

“Even commodities such as oil and minerals (think fracking, ground radar and computer simulations) are keeping price pressures down.”

Anyone who has spent decades investing for captives, as I have, has seen this story before. But this time it seems, and feels, different.

When someone in this business claims “this time is different” it should set alarm bells ringing. In fact, while the relationship between apparently palpable inflation and Fed action seems different this time, things are in fact progressing much as they usually do. The Fed is betting on growth, not on inflation.

Many people know the saying: “Don’t fight the Fed.” The Fed is pumping liquidity into the markets, as it has done for a long time. It has accelerated the speed of the printing press even more during the pandemic. Under these circumstances, I believe it behoves the investment community either to jump on the train and buy stocks and bonds, or to get out of the way.

In my opinion no other entity on earth has the financial might of the US Federal Reserve Bank. When it decides to print $6 trillion in one year, there is really only one way the markets can sustainably go, and that is up. For stocks that means higher prices, and for bonds that means higher prices and lower yields.

This time last year the Fed printing press and fear of the COVID-19 pandemic, coupled with the painful sting many investors endured in Q1 2020, had investors ploughing money into Treasuries. After a strong 2019, the 10-year was yielding over 1.85 percent, but by the time the stock market bottomed in March 2020 it yielded as little as 0.54 percent, which was unheard of.

As the stock market recovered and investors sold some bonds to buy stocks, the yield went back up slightly, only to fall again to a low of 0.5069 percent by August 4, 2020, another record low.

While stocks climbed through the balance of 2020 and into 2021, interest rates predictably moved up and the value of the 10-year Treasury fell. By March 31, 2021 the rate was over 1.74 percent, reflecting about a 10 percent loss for Treasury investors who bought the bonds last summer.

Here is where it gets interesting: the stock markets continued to rise, with the S&P 500 ending Q1 2021 just a hair under 4000 and marching steadily to over 4350 as of Independence Day 2021. Yet the 10-year also rose in value, with the yield dropping to below 1.4 percent. Apparently the age-old relationship between stock and bond prices had decoupled. What is going on?

Relative values, inflation stickiness, monetary policy and drunken sailors

This decoupling is the result of a Fed printing money, uncertainty about whether inflation will prove sticky, and a government determined to spend money like a drunken sailor, literally pouring gas (money) on an already hot economy. Government promises to increase spending via ersatz-infrastructure bills—most of which are more entitlements and handouts—had stock investors convinced that the sky is the limit.

At the same time bond investors seem less worried that the inflation of today will stick. They believe inflation will be “transitory” as the millions of workers sitting on the sidelines collecting enhanced unemployment cheques (by some measures over 60 percent of the people on unemployment are making more staying home than they did working) will flood back into the labour market in September.

This is expected to cool the wage inflation that has been caused by the economy reopening while the government continues to pay people to not work. I think it will help.

I believe that technology in disinflationary, and today everything is a technology product. Whether it is artificial intelligence and machine learning helping to automate rote work, or to analyse complex insurance loss scenarios, the cost of doing business is generally falling. In many cases working from home accelerated the trend. Even commodities such as oil and minerals (think fracking, ground radar and computer simulations) are keeping price pressures down.

There is a very good chance that, after the entire world’s supply chains were “snapped” during the pandemic and needed to be rebuilt and restarted, they will come back online fully, but better and cheaper. This is the bet the Fed is making by keeping rates at zero. This is the bet that the bond market is making by having rates fall in the face of obvious inflationary evidence.

As for me? I won’t fight the Fed!

Jack Meskunas is a financial advisor at Oppenheimer & Co. He can be contacted at: jack.meskunas@opco.com