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After the U.S. Federal Reserve Board’s (Fed) June interest-rate-setting meeting, Fed Chair Jerome Powell announced that the central bank had decided to contemplate rate hikes in 2023, with a possible two increase pencilled in on the so-called “dot plot.” This is a pictogram that indicates when members of the Fed think interest rates will be over the next couple of years, with a series of dots representing each Fed meeting this year and next. He also indicated that the Fed was beginning to think about discussing tapering, or the gradual withdrawal of its monthly purchases of government and corporate bonds, funded by quantitative easing (QE), in effect money printing.
The reaction to these fairly anodyne statements was dramatic, as long term U.S. Treasury bond yields, saw a sharp drop, with the 10-year yield dropping to below 1.4%. As recently as a couple of months ago, it was at 1.75%, so the slide in the last few weeks has been very marked. The U.S. dollar, which had been down over 10% on a trade weighted basis against a basket of major currencies and over 15% against the Australian and Canadian dollars and the U.K. pound, strengthened markedly as well, while economically-sensitive sectors, such as mining and financials, as well as perceived safe havens such as precious metals, all sold off sharply.
The reason for these moves can be found in how lopsided sentiment had become, with large numbers of investors positioned to benefit from U.S. dollar weakness and higher inflation, with the U.S. CPI inflation figures for April and May coming in at 4.2% and 5%, ticking up to 5.4% in June. As long as investors believed in the messages from the Fed, and other central banks such as the ECB and the Bank of England, that short term interest rates would remain at generational lows near zero for the foreseeable future regardless of how high inflation was, then betting against the U.S. dollar and having positions in inflation beneficiaries was very easy.
Mr Powell and other central bankers had stated that they were now looking at the the average rate of inflation over time as a target, rather than a specific number. Thus, although the Fed’s CPI inflation target is 2%, as inflation had been well below that level for most of the last 18 months due to the pandemic and the lockdowns imposed to contain it, the implication was that the Fed would be unconcerned even if CPI rose to well above that level, as indeed it has.
This reminds us of the famous quip about the problem with averages: if someone has one foot in a block of ice and the other is in a pail of boiling water, then on average, they will be at a comfortable temperature! While inflation was artificially depressed by the collapse in demand in the second quarter of 2020, and therefore the comparisons with the very low numbers last year means this year’s inflation figures will be very high, the Fed and many observers are convinced this spell of higher inflation is “transitory,” a synonym for temporary.
Therefore, they don’t feel the need to take any immediate action to quell this bout of rising prices, as once the low base numbers from last year drop out, the inflation rate will fall back to below their 2% target. The fact that the Fed has indicated that it will bring forward the possibility of tapering its QE program and raising interest rates has been enough to reassure worries investors and send the assets that have been worst affected by worries over rising inflation and the near certainty of a very strong economic rebound, primarily long-dated government bonds and defensive sectors such as utilities as well as some of the FAANG+ winners of last year, rebounding sharply.
iShares Core Canadian Long Term Bond Index ETF (TSX: XLB), probably the most sensitive indicator of inflationary fears, which is down 7.5% so far this year to June 30 and down 7.1% over the last 12 months, has jumped 5.9% in the last three months ending July 31. Apple, Tesla, and the green energy sector, also big winners last year from government policies to favour clean, renewable sources of power, are all up strongly in the last month after suffering sell offssince the beginning of the year. Investors have moved into economically-sensitive sectors that had lagged during the pandemic, particularly those where supply constraints meant suppliers had pricing power.
This is really what the thoughtful investor needs to consider when they wonder whether this potential move towards tightening by the Fed will lead to an end to the recovery trade, which has been the dominant theme so far this year in markets. As someone unkindly observed, promising to raise interest rates twice in two years time with inflation running at 5% is like saying you are eating too much but will go on a diet in two years.
If the central banks are wrong about inflation being transitory, then by the time they get around to raising interest rates, even if they bring the decision forward to next year in 2022, inflation may by then be well established. As the evidence of the 1960s and 1970s demonstrates, once people have become accustomed to an environment of rising prices and wages, it’s very hard to change that mentality.
Under the late, esteemed Fed chairman Paul Volcker, the U.S. central bank had to be prepared to raise interest rates to 15% in 1979-80 to break the inflationary psychology. Initially investors didn’t believe the Fed and Mr Volcker meant it. But gold shot up to over $800 an ounce in the six months after interest rates were abruptly raised in late 1979, while oil prices topped $40 a barrel in the aftermath of the overthrow of the Shah of Iran and the arrival of the radical Iranian regime.
Only when it became apparent that the central bank was prepared to keep interest rates at a very high level for however long it took – regardless of the short term pain to the economy – did investors’ attitudes change and inflation drop rapidly. Some observers felt that Mr Volcker was as responsible for President Jimmy Carter’s defeat by Ronald Reagan in 1980 as the Ayatollah Khomeini, as he became the first elected incumbent to lose since Herbert Hoover in 1932. Many others, however, thought that while the Great Depression had brought down Hoover, so the Great Inflation, with the CPI over 12% in 1980, did for Carter.
Whether the present Fed will be willing to raise interest rates sufficiently to deal with inflation if it isn’t transitory is an interesting question. While Mr. Powell raised short-term rates to 2.5% at the end of 2018 from 0.5% in 2016, while reducing the amount of QE (tapering) at the same time, he abruptly reversed course at the end of that year when the stock market sold off by 20%.
This doesn’t give one a great deal of confidence that the central bank will be willing to cause the pain of a stock market selloff to break inflationary psychology. Investors will have to get used to living with higher inflation for the foreseeable future unless, of course, it is just due to recovery from the pandemic and temporary supply bottlenecks and a one-off jump in demand from consumers, who can finally go out and spend.
Gavin Graham is a veteran financial analyst and money manager and a specialist in international investing, with over 35 years’ experience in global investment management. He is the host of the Indepth Investing Podcast.
Notes and Disclaimer
© 2021 by Gavin Graham. This article was originally broadcast as a podcast on Indepth Investing, hosted by Gavin Graham. Used with permission.
The commentaries contained herein are provided as a general source of information based on information available as of June 24, 2021, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
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