Tag Archive: Fed

Inflation is steady on the surface, volatile underneath

Inflation expectations have been a topic of growing interest thanks to the extraordinary fiscal and monetary support in place for much of the last year, most recently the huge $1.9 trillion American Rescue Plan that is currently sending checks out to millions of Americans.

All of this new spending by the federal government, along with the economic recovery permitted by the rollout of COVID-19 vaccines, is provoking more discussion about whether demand for goods and services will outpace the economy’s ability to produce them and push prices higher.

While we have previously discussed why we do not think inflation will be a major problem in the next few years, investors in the Treasury market appear to have raised their forecasts for future inflation, at least in the near-term. This is reflected in the “breakeven rate”, which is the difference between the yield on nominal Treasury bonds and that of the corresponding TIPS (Treasury Inflation Protected Security) bond. TIPS provide a “real” interest rate (currently negative) plus whatever the rate of inflation is over the bond’s duration. The difference between nominal and TIPS yields indicates the level of inflation that would produce the same return to holding either type of bond after accounting for inflation.

The chart below shows the breakeven rates for five-year and 10-year maturities, and we see that the five-year inflation expectations in particular have risen sharply recently, now back to levels around 2.5% seen after the last two recessions. The 10-year breakeven rate has risen less, as investors appear to expect a temporary jump in inflation that will subsequently ease. Both figures are roughly in line with the Fed’s stated inflation target, and thus are unlikely to provoke a tightening response at this point.

Breakevens 5yr 10yr_032521

Source: Mill Street Research, Bloomberg

Reported inflation, as measured by the Personal Consumption Expenditure (PCE) Price Index (the Fed’s preferred measure), has remained low thus far. Year-on-year comparisons will soon be skewed by the price drops around this time last year when the economy buckled under the weight of COVID and the associated limits on activity. Overall, however, there are thus far few signs of significant overall inflation in the reported data.

When we look under the surface of the inflation data, however, we find that there are a lot of significant changes going on among the various components, which are thus far mostly offsetting each other. This is not unusual around recessions, and certainly consistent with the extreme and unusual kind of shock that COVID-19 has caused in the economy.

The Federal Reserve Bank of San Francisco publishes metrics that capture the dispersion and amount of underlying change in the inflation rates of the various categories of goods and services measured in the PCE data. The charts below show the increased levels of “rotation” under the surface of the muted headline PCE inflation measures.

The first chart below shows the last 15 years of data on the PCE headline (total, dark blue line) and core (excluding food and energy, red line) inflation rates along with measures of the dispersion among the 100+ granular subcomponents of the PCE inflation data. It shows the inflation rate for the 90th and 10th percentile subcomponents of the PCE price index and below that the spread between the 90th and 10th percentiles as a measure of the cross-sectional dispersion or variation of inflation rates among products at any given time. We can see that dispersion in inflation rates among the categories of PCE components has widened significantly recently to 6-7%, up from readings closer to 4% for much of the last several years.

Also notable is the fact that even the subcomponents with the highest inflation rates (the 90th percentile, purple line) have price gains of only about 4%, marking a fairly modest upper bound on inflation pressures so far.

PCE Inflation and DispersionSource: Mill Street Research, Federal Reserve Bank of San Francisco

With some prices falling substantially, the current inflation spread (90th vs 10th percentile) is among the widest in the last decade, and it quantifies and corroborates the intuition that the supply and demand impacts of the COVID-driven recession and recovery have led to more divergent outcomes for different industries (some hurt badly, some benefiting strongly). The inflation spread widened even more dramatically around 2008, driven by enormous volatility at that time in energy prices in particular, and there was less direct fiscal stimulus support in that recession than the current one.  This analysis helps make the point that the gap between winners and losers seen in the stock market has a fundamental driver visible in the inflation data.

The final chart below plots another way of looking at the underlying divergences beneath the surface of the headline inflation data. The same San Francisco Fed data set also calculates the percentage of PCE price index subcomponents that have had large changes in their 12-month inflation rates relative to their previous five-year averages (“large” meaning two standard deviations from the five year average). Industries that have seen their inflation rates lurch upward would be captured in the blue line, showing the percentage of all PCE components with large upward movements in inflation, while those facing big downward changes would be captured in the red line.

Proportion of Big Changes in PricesSource: Mill Street Research, Federal Reserve Bank of San Francisco

The grey line below plots the sum of the two series to provide a measure of how many industries have seen major shifts in their respective inflation trends. Here we see that 25-30% of industries have recently had major shifts (up or down) in pricing power relative to their longer-term trends, much higher than the usual 5-15% readings for most of the last decade.

We also see that current readings are at similar levels to those seen around the 2008 recession, though with a slightly different pattern: in 2008, there was initially a spike in price increases, then a spike in price decreases, while this year has seen concurrent but less extreme spikes in both series as demand and supply had to simultaneously adapt to COVID’s impact on activity.

The implication is that some industries that may have had weak pricing power pre-COVID now have stronger price trends, while others that had higher industry-level inflation are now under more pricing pressure. While there are always a few such industries at any given time, there are many more right now.

These data help provide some further fundamental corroboration for the rotation in stock market industry trends and wide gaps between winners and losers, even in an environment of continued low headline inflation rates.

Bond market making some noise

The bond market has clearly awoken from what appeared to be a low-volatility Fed-induced slumber for much of last year. Longer-term bond yields in the US and elsewhere have jumped to their highest levels since just before the COVID crisis hit markets early last year (blue line in first chart below). Even after this rise, though, the 10-year Treasury yield remains below even the low points of previous cycles.

Short-term rates (0 to 2 year), meanwhile, have remained anchored near zero due to the Fed’s continued indications that any policy rate hikes are still at least two years away.

US Treasury Yields

There are two main components to Treasury yields (which do not have default risk): real yields (yield after subtracting expected inflation) and inflation expectations. The first component to move was inflation expectations (first chart below), and more recently real yields (second chart below) have also risen notably. However, real yields remain solidly negative and much lower than they were before COVID-19 hit last year.

Breakevens 5yr 10yr

Treasury 10-yr Real Yield

What have been the drivers of the recent move higher in long-term bond yields?

Some of the most prominent reasons include:

  • Additional fiscal stimulus is expected soon, which will potentially boost inflation and growth, and also require the issuance of a large amount of new Treasury bonds.
  • The economy’s recovery from COVID-related weakness is continuing thanks to ongoing vaccinations, which will combine with stimulus to push growth much higher than average this year.
  • Sharply higher prices for oil and other key commodities (copper, lumber, etc.) are raising concerns about inflation already in the pipeline, with further demand potentially driving prices even higher.
  • Selling or hedging activity by investors who trade leveraged positions in bonds, and/or own mortgage-backed securities that now appear riskier. Rising mortgage rates typically reduce pre-payments (due to less housing turnover) and refinancing of home mortgages, which increases the duration, and thus risk, of mortgage-backed bonds.

The jump in market-implied inflation expectations has been quite sharp, though something similar happened after the 2008 crisis period as well. The current inflation expectations reflected in 5-year and 10-year Treasuries (difference between nominal Treasury yields and inflation-protected TIPS yields) are now slightly above the Fed’s 2% inflation target. Indeed the 5-year implied inflation rate (breakeven rate) is at its highest level since 2013, and the 10-year rate touched its highest since 2014. Investors now appear to expect a rebound in inflation, which is likely not considered a problem by the Fed (given their stated inflation goals) as long as expectations do not become excessive. However, the Fed’s own buying of TIPS in the past year may itself have skewed the interpretation of “market expectations”: the Fed now owns well over 20% of the entire TIPS market, potentially influencing their prices (yields) more than usual.

For stock prices, a moderate amount of inflation is not necessarily a bad thing for corporate earnings, as long as it does not provoke Fed tightening. Since equities (via corporate profits) are partly hedged against inflation, real yields are often viewed as the more important rate. Thus the recent rebound in real bond yields has raised concerns about equities losing the tailwind they have had from falling real yields for more than two years. It has also provoked a shift in investor interest from Growth stocks that are attractive when economic growth and inflation are low toward Value (and other riskier) stocks that tend to do better when economic activity and inflation are accelerating.

With short-term yields still pinned near zero by the Fed, the yield curve has steepened sharply recently. This is notionally good for Value-oriented banks and other “spread lenders” (who borrow at short-term rates and lend at long-term rates), though many other factors can affect the profitability of lending, and higher rates can dampen loan demand.

And one of the biggest impacts of higher long-term yields is in fact on mortgage rates and thus the housing market. Housing has been an extremely hot area recently, as demand for single-family homes is very high and supply has been unusually low. The average 30-year mortgage rate recently hit an all-time low of about 2.8% but has now jumped back up to 3.14% in just the last two weeks (and will likely rise somewhat further near-term). While this is still very low by historical standards and may not hamper housing too much, at the margin it may cool demand, and any further increases would put additional pressure on housing demand.

Overall, a moderate rise in long-term yields with well-anchored short-term rates is not necessarily a major cause for concern for stocks, or the economy, in general. It does however mean potentially more rotation among sectors and styles within equities. It will also bring up concerns about whether or when the Fed will decide to alter its current policy trajectory in response, as too much of a rise in yields could cause economic dislocations that the Fed would prefer to avoid.

Putting the Fed’s balance sheet in perspective

Along with fiscal stimulus, the aggressive support of financial markets by the Federal Reserve (and other central banks) has been a key to the gains in risk assets since April. In our view, stock and bond prices would not be as high as they are if not for the perception that the Fed will step in with additional support if markets get too volatile. This perceived “Fed put” is on top of the ongoing bond buying programs (excluding the immediate post-COVID surge) that are currently running at a rate of about $80 billion per month for Treasuries and $40 billion per month for mortgage backed securities, though some of this replaces expiring bonds.

So the Fed continues to have a heavy influence on debt markets, and thus indirectly on equity and other financial markets.

The size of the Fed’s balance sheet (the value of all assets it holds) used to be far smaller relative to the economy or the markets, and only began to be a major part of the monetary policy toolkit in 2008 in response to the Great Financial Crisis. Previously, the Fed’s control of short-term interest rates was sufficient and did not require as much balance sheet activity, but once short-term policy rates hit zero in 2008 (and again this year), new tools were needed.

The chart below plots the ratio of the Fed’s balance sheet to US nominal GDP, perhaps the most common way of putting the Fed’s monetary policy actions in perspective. From a pre-crisis level of around 6% of GDP in 2007, three rounds of quantitative easing (“QE”, or bond buying) starting in 2008 pushed the ratio up to about 25% of the size of the US economy in 2014. Then the Fed allowed some assets to “roll off” (bonds maturing and not being replaced with new ones) and effectively shrink the balance sheet relative to the economy. Several years of such a policy brought the balance sheet back to about 18% of GDP in early 2019.

Fed Balance Sheet Pct of GDP

This appears, in hindsight, to have been too small a size for the Fed’s balance sheet nowadays. It is important to recall that even before COVID hit earlier this year, in mid-2019 the Fed began lowering rates and adding to its balance sheet again to ward off interbank funding strains and signs of weakening economic growth. Then in response to the COVID-related shutdowns of the economy, the Fed made its most aggressive balance sheet movement to date. It bought nearly $3 trillion in Treasury, mortgage-backed, and other bonds very quickly, pushing its balance sheet size up to its current record level of about $7 trillion. This is now about 36% of US GDP.

While comparing the Fed’s assets to the size of the economy is a relevant comparison, we should also keep in mind that financial markets have generally grown faster than the economy. So it is also worth considering the Fed’s balance sheet in relation to the size of the debt and equity markets.

Notably, even with huge issuance of Treasuries recently to finance the US federal budget deficit, the Fed now owns over 20% of all publicly held Treasuries, more than it has in at least 20 years.

And it owns more than 30% of the mortgage-backed bond market, similar to what it owned in the aftermath of the Great Financial Crisis (which was heavily tied to the mortgage and housing market). This has helped push mortgage rates to all-time lows recently.

The chart below, however, plots the Fed’s balance sheet relative to the size of the US equity market. Now, to be clear, the Fed does not own US stocks (at least not yet, though other central banks like those in Japan and Switzerland do buy stocks), so this is just another way to scale the size of the Fed’s balance sheet (bond holdings) that may be of more interest to equity market participants.

Fed Balance Sheet Pct of US Market Cap

We compare the value of the Fed’s assets to the total equity market capitalization of the broad Russell 3000 index (the 3000 largest US companies). The picture there is notably different than the one using GDP as the scaling metric.

The initial surge in 2008-09 is very stark, pushing the balance sheet from around 7% of equity market cap up to a peak around 25%. Then the balance sheet oscillated around 20% of US equity market value as the Fed’s bond buying was roughly in line with the growth in the equity market through 2016. When the Fed began allowing its balance sheet to gradually decline, stocks continued higher and thus the Fed’s assets dropped sharply to a low of around 13% of equity market cap in 2019.

The Fed’s actions this year have provoked another jump in the ratio, but the change relative to the stock market has been less than that seen in 2008-09, due to the larger size of the stock market. The peak earlier this year was around the same 25% level relative to US equity market value, and since then the gains in stocks have outpaced the Fed’s buying of bonds and pushed the ratio back down somewhat.  The Fed’s assets now equal about 21% of US equity market value, not far from the average level during the 2009-2016 period. This reflects the fact that the stock market has grown significantly faster than US GDP in recent years as equity valuations have risen.

We can thus see that while the Fed is more involved than ever in financial markets by some metrics, by others it is not far from the ranges it has inhabited since the Great Financial Crisis started 12 years ago. And we should keep in mind that other central banks (Bank of Japan, European Central Bank) have balance sheets even larger relative to their economies or their financial markets. So the Fed could certainly continue expanding its asset purchases further before it would approach the relative size of some of its counterparts.

The Fed is thus both limited and nearly unlimited: it can print money to buy bonds (including corporate bonds now), i.e., make loans, in almost unlimited quantities, but cannot determine how the money they print is used (or not used), and cannot give outright gifts or grants. Only Congress, via the Treasury, can distribute truly “free money” that does not have to be paid back. And recent headlines suggest further delays in new fiscal policy support. That leaves the Fed as the main provider of market support, at least for now.

In case you need a refresher course, it’s all stimulus these days

*with apologies to Irwin M. Fletcher

Much has been made about the divergence between the path of the US (and global) economy and that of the stock and corporate bond markets. Even while economic and earnings growth is historically weak and remains under severe pressure from a rapidly spreading virus, major stock market indices have rallied and are at or near all-time highs. Market valuations based on forecasted earnings over the next 12 months have clearly risen sharply.

While the divergence between financial asset prices and the “real economy” as experienced by many Americans is striking, the reason is not hard to see: enormous levels of stimulus by both fiscal and monetary authorities.

Essentially, the US Congress has voted (in four separate pieces of legislation so far) to drastically increase deficit spending to support individuals and businesses as well as the costs of health care and virus abatement. The trailing 12-month US federal deficit has jumped to about $3 trillion, easily a new record in nominal terms and the largest deficit as a percentage of US GDP since World War II.

As shown in the bottom section of the chart below, the current 12-month deficit is now nearly 14% of nominal GDP, significantly more than the peak following the Great Financial Crisis, and up from the deficit levels of 4-5% of GDP in 2018-19, i.e,. adding roughly 10% of GDP to spending. This has helped fill a huge gap in personal incomes caused by lockdowns associated with COVID-19.

US Monetary and Fiscal Stimulus

And crucially, at the same time, the Federal Reserve has also engaged in an unprecedented level of money creation (“quantitative easing”, or QE) to essentially monetize the increase in Treasury debt. After immediately cutting its fed funds policy target back to zero (0 – 0.25%), the Fed has expanded its balance sheet from around 20% of GDP before COVID-19 hit to over 30% of GDP currently, i.e., adding roughly 10% of GDP to the money supply. This is also far bigger than its balance sheet was after the three previous rounds of QE between 2008 and 2014.

While the Fed has a number of different programs in place to support financial markets and the economy, most of what it is doing is buying up Treasury bonds, mortgage backed securities, and more recently corporate bonds and bond ETFs. It does this with newly created money that can then circulate in the economy. A key effect is to essentially offset the absorption of money caused by the Treasury issuing huge amounts of new bonds, and has drastically expanded the US money supply. And by using newly-granted powers (under the recent CARES Act) to buy corporate debt (including some high-yield or “junk” debt), it has also compressed the credit spreads in the corporate bond market and made it cheaper for companies to borrow than it otherwise would be.

So an extreme oversimplification would be that the Treasury engaged in new spending of something on the order of 10% of GDP, and the Fed printed roughly a similar amount of new money to “pay” for it (a liquidity conversion of the Treasury bonds to cash), with some of that Treasury money being used to allow the Fed to take on corporate credit risk for the first time. That extra ~10% of the economy that has been conjured up by Congress and the Fed was meant to fill some of the hole left by the meteor that hit the global economy in the form of COVID-19.

The key question now is to what degree is additional stimulus needed, and will policy makers provide it to the appropriate degree? Current virus trends, structural economic damage COVID-19 has already caused, and rising debt levels suggest significant further stimulus will be required to bridge the gap until the economic effects of the virus have passed, though that remains a point of debate.

Investors who take the view that the policy response will be sufficient (or possibly even excessive) are likely those who are content to pay the same (or higher) prices for stocks and some bonds than they did in 2019, and assume that earnings will fully recover and stocks will be worth more in the future due to the lack of any competition from near-zero interest rates on safe debt (Fed policy rates are expected to remain near zero for several years at least).

Investors who worry that the policy response will falter may be more cautious, given the potential further weakness in corporate earnings that would also result. And one outcome in particular bears consideration: what if the fiscal response falters (due to Congress being unable to agree on sufficient stimulus legislation), but the Fed continues to intervene heavily in financial markets with quantitative easing and corporate credit spread compression (i.e., printing more money than can readily be spent)? Then financial assets, and unprofitable companies, might continue to hold up and inflation could eventually rise, even while the underlying economy weakens (with implications for income and wealth inequality).

That is arguably not far from what is happening now, as the Fed has adopted a “whatever it takes” approach and has few limits to the amount of monetary support it can provide. The question of further fiscal stimulus is the key question right now, as there reportedly remains a wide gap between Democrats and Republicans in Congress (and the White House) about the size and scope of any additional stimulus. With much of the original stimulus plans now fully utilized or expiring soon, there is a clear danger of a de facto sharp contraction in fiscal policy relative to the current extreme levels of support (the so-called “fiscal cliff”). Congress is scheduled to be in session for only a couple of weeks before going on August recess, and the key $600/week of extra unemployment benefits are due to expire on July 25th. The path of the economy and financial markets may depend on decisions made by Congress in the next few weeks.