Stew’s Views: April 18, 2022

April 18, 2022

Breaking Down the Fed’s Inflation Playbook

Raising rates to tame inflation is a play right out of the economic textbook. As the US CPI inflation rate has moved from below 1% last year to the current 8.5%, the Federal Reserve is being forced to drain liquidity from the system as “too much money is chasing too few goods.”  

The Fed is threading a needle—in their own forecasts, the central bank envisions being able to raise the overnight rate to restrictive territory (above the neutral fed funds rate), while at the same time keeping the economy growing above 2.5% and the unemployment rate in the mid 3%’s.  Accomplishing all that will be no small task, particularly as the signs of a meaningful economic slowdown are abundant.    

Is the Housing Market Cooling Off?

Firstly, housing has been on a tear over the past year, with nominal price rises close to 20% on a year over year basis. Low mortgage rates and wealth increases from equity market gains and incomes have helped create a rapid rise in housing prices in most parts of the country.   However, signs are evident that a cooling off in this sector is inevitable and on the near horizon.   Between higher costs of living from the rise in gas, food, and everyday essentials, to the increase in mortgage rates, the froth in the housing market is beginning to dissipate.  See below for the charts of Bankrate.com US Home Mortgage 30 Year Fixed Rate Average, and Existing Home Sales seasonally adjusted annualized rate.

Mortgage Rate

Source: Bloomberg

Existing Home Sales:

Source: Bloomberg

Why Focus on Freights?

Separately, the heartbeat of the economy is the freight industry.  There is little surprise that market players focus on the Dow Jones Transportation Index as a leading indicator for both the US equity market and the broad economy, as it’s often argued that “transportation knows first.”

If that old adage is true again, the slowdown in the US economy will be both material and arriving very soon. Freightwaves, a well respected data collector and reporter on the transportation sector, recently wrote that, “More than likely, the lower volumes (in the freight market) are due to a major consumer slowdown. Inflation that began in 2020, combined with the surge in fuel prices related to increased inflation and the Russian invasion of Ukraine, have made consumers move to the sidelines. Market participants are confirming what FreightWaves analysts are seeing in the data. Spot rates are falling fast and volumes are dropping.”  

This slowdown in the transportation sector is surely a sign of demand destruction, as the high and rising prices of goods and services are finally starting to bite the consumer—and the pullback is becoming apparent in numerous aspects of the economy.   See the chart below (courtesy of FreightWaves) comparing 2022 freight volume vs 2021. Freight traffic in March, which is typically a seasonally strong month, has fallen sharply:

Source: Freightwaves

A Predictive GDP Downshift

Lastly, the Atlanta Fed GDP NOW forecast, an always reliable indicator for US growth, has downshifted dramatically—currently calling for q1 2022 GDP of just 1%. After the 5.5% GDP of 2021, this is a material slowdown—and much of it doesn’t reflect the war in Ukraine, which happened in the last month of the quarter, and the recent tightening of financial conditions that has materialized from the stronger dollar, higher rates, wider credit spreads and weaker equities.  

Can the Fed Execute a ‘Soft Landing’?

From the market signal of an inverted yield curve to the signals from the leading edges of the economy, we feel confident that the Federal Reserve’s ambitious forecasts and plans of meaningful rate rises to engender lower inflation will be hard pressed to lead to stronger employment and higher growth. Much has been written about the Fed’s ability to engineer a soft landing, and how the 1994 Fed rate hike cycle analogy shows that “past is prologue” and higher rates can lead to just a modest drop in GDP.  

We take issue with comparing the current situation to that episode, as the economic environment was much different in 1994 than it is today.  Most importantly, the inflation rate was never above 3% during that period—compared to its current 8.5%.  The Fed’s heavy lifting to drain liquidity in the current cycle will entail tightening from both ends of the curve—overnight rate rises, and just as importantly, Fed balance sheet reduction. For this, there is no historical precedence.

The Continued Case for Short-Duration Fixed Income

At YieldX, we continue to advocate in favor of well-constructed, short-duration fixed income portfolios.  The market is currently PRICING IN a further 300 basis points of rate rises over the next 18 months, including 50 basis point rate hikes at both of the next two Federal Reserve meetings in May and July.  In addition, $95 billion a month in Federal Reserve balance sheet reduction has now been socialized after the details of the program were in the Federal Reserve Minutes released last week, and via comments from members of the Federal Reserve.  Two-year yields in the US are no higher than where they were a few weeks ago, even as the headlines are screaming BOND BEAR MARKET.  

 A lot of bad news is priced into the front end of the markets.  Using our tools, we can build portfolios with durations of 1.5 years with investment grade bonds at yields close to the fed funds rate that’s priced in late 2023, and high yield portfolios with the same duration that are 100bps higher than that yield. The timing is good, the yields are meaningful more than the recent past, and the fundamental backdrop given the signals of economic slowdown argues for it.

about the author

Stewart Russell, Chief Investment Officer

Stewart Russell is Chief Investment Officer. Previously, he was Managing Director, Head of Institutional Solutions and Head of Multi-Asset Portfolios at Barings. Stewart was also a portfolio manager at Moore Capital Management and Partner and Co-Chief Investment Officer at Fischer Francis Trees and Watts, sold to BNP Paribas during his tenure.