LOOONG post for economics nerds:
The stock market corrected in the first quarter of 2022 in reaction to a rapid change in market expectations about how soon the Federal Funds Rate would be hiked, and how soon the Fed would reduce its $9 trillion balance sheet. It's fair to say the path of our investments for the next couple of years is mostly dependent upon the next handful of inflation readings.
The purpose of this post is to gather links to data sources which could help us learn more about forecasting the short-term future of inflation, and watch as the variables change over the pivotal next few months.
The key question seems to be:
How long will we experience higher monetary velocity caused by the unprecedented stimulus of the $2.2T 2020 CARES Act, the $1.9T 2021 American Rescue Plan, and smaller stimulative acts of the past two years? Will the extra money in the system quickly find its ways to overseas reserve banks and the stagnant accounts of rich people holding US Treasuries, and out of circulation in the real economy? Or will most of the money keep bouncing around in the real economy, contributing to monetary velocity for years, and requiring even more rate hikes than the market expects?At the time of this OP, the market has priced in the following inflation expectations, which I would characterize as rather tame compared to the inflation hype and headlines:
20 year: 2.81%. Source:
https://fred.stlouisfed.org/series/T20YIEM10 year: 3.02%. Source:
https://fred.stlouisfed.org/series/T10YIE7 year: 3.14%. Source:
https://fred.stlouisfed.org/series/T7YIEM5 year: 3.41%. Source:
https://fred.stlouisfed.org/series/T5YIEMThis means the bond markets (typically the smartest and most accurate forecasters in the investment world) are expecting:
a) Severe Recession Scenario: a massive disinflationary recession within the next couple of years that will cause the 5-year average inflation to fall to 3.4% despite today's 8%+ inflation readings (e.g. 3.4% = AVERAGE(8%,
0%,3%,3%,3%), OR...
b) Transitory Scenario: a rapid collapse in inflation - the "transitory" narrative but on a longer time scale than people were thinking last year. This would be because we went from $4T+ stimulus and QE in the last couple of years to zero all of a sudden in 2022, with rising interest rates too, and about a year of lag time (e.g. 3.4%=AVERAGE(8%,2.2%,2.2%,2.2%,2.2%). This would be the "soft landing" scenario in which monetary velocity returns to the existing trendline. OR...
c) Fed Overreaction, a scenario in which inflation collapses for its own reasons at the same time as the Fed tightens policy and we're close to recession/deflation again in 12-24 months. In this scenario, the Fed has a delayed overreaction to what would have been transitory inflation. They ignore the short-term causes (stimulus legislation, commodity shortages) and tighten money supply just as the economy is slowing anyway. Recession occurs and rate hikes are stopped at about the level the bond market is predicting.
CaveatsThese simple scenarios do not, of course, account for the possibility of a financial crisis as bank assets devalue (guess who suffered the epic bond losses of the past 6 mos?), a real estate crash causing a repeat of 2008, or a sovereign bonds crisis in highly leveraged countries. They also do not account for potentially rapid earnings growth, improving logistics, and the full employment we are currently experiencing. So the portfolio consequences might not correlate 1:1 with interest rates.
The transitory scenario seems like the only one with the potential for a positive stock market outcome, such as would occur if earnings growth and a rapid decline of the inflation rate both overwhelmed the effect of higher rates or reduced everyone's expectations for future rate hikes. Markets had a little rally in March when the inflation trajectory seemed to be flattening, because if inflation started going down then the Fed might not end up hiking much after all. We will know by THIS SUMMER if the transitory scenario is happening.
Core CPI:
https://fred.stlouisfed.org/series/CPILFESL#0Historical Accuracy of the Bond Market in Predicting InflationThe last time there was a big gap between CPI and inflation expectations implied by TIPS yields was 2007-2008. Back then, the bond market held its 10y expectations in the 2.5% range despite month after month of inflation readings in the 4-5% range. The bond market was right about inflation coming down soon. When the deflationary financial crisis actually hit, TIPS and regular treasuries suddenly started trading at the same yields, and so the market briefly predicted 0% average inflation for the next decade (i.e. a worse economy than the great depression). Other than this error, the bond market has been a fairly accurate inflation trend forecaster for decades. Today, the bond market appears to be expecting inflation to come back down quickly, just like in 2007-2008. However the gap between forecasts and actuals is much bigger than in 2007!
Historical Predictions vs. Actual Source:
https://www.yardeni.com/pub/expectinflat.pdf figure 3
Personal ConsumptionOn the flip side, the Personal Consumption Expenditures metric (set to % change from year ago) suggests consumers are still spending like drunk sailors. You can practically see the arrival of stimulus checks on the graph, and the effect of all that money ricocheting throughout the economy. PCE is holding up so far in 2022, suggesting the stimmie checks have not yet all made their way to China. So inflation could continue a while.
PCE Source:
https://fred.stlouisfed.org/series/PCE#0Savings RateThe counterpoint to this argument is the observation that the Personal Savings Rate has plummeted to below the pre-COVID trend. Maybe consumers are flush with stimulus cash, feel secure in their employment, and don't feel the need to save any more? Or maybe they have already blown through their stimulus cash and are now spending out of their savings jars? Or maybe they're not saving as much because they're buying stuff now in anticipation of rising inflation later. In any case, maybe consumers don't have a pile of savings to sustain their current spending spree? The high savings rates during 2020-2021 were a bullish sign, but now we've gone the other direction. This supports the case for falling monetary velocity.
Savings Rate Source:
https://fred.stlouisfed.org/series/PSAVERTInventoriesWill inventory shortages continue to prop up prices? Not according to this chart. Businesses seem to have recovered from pandemic-era logistics and manufacturing challenges, and inventories are now back on the trendline. This supports the case for falling inflation.
Inventories Source:
https://fred.stlouisfed.org/series/BUSINVMoney SupplyMoney supply charts show the $4T stimulus as an increase above the trendline of... about $4T. The Fed is now discussing selling about $95B per month of its assets to reel in some of this excess money from the economy. They could flatten the growth of M2 like they did in 2009-2010, which would contribute to low post-stimulus inflation just like it did in 2009-2010. I don't think M2=inflation like some of the internet simpletons who were calling for hyperinflation in 2011 and haven't changed their theory to match the facts, but I do think rapid growth or contraction in M2 suggests a change in monetary velocity. A flattening money supply like we can anticipate now implies low inflation in the future.
M2 Source:
https://fred.stlouisfed.org/series/M2NS
Monetary "Leakage"The rapid growth of money supply after the Great Financial Crisis led many people to think inflation would rise. A price bubble soon formed in the price of gold, spurred on by countless financial media articles, and then popped when the inflation failed to materialize. There are several reasons why rapid growth in M2 did not translate into monetary velocity. These reasons have been with the U.S. for decades and are only accelerating:
1) Demographic graying: We're now where Japan was in the mid-early 90's. Old folks spend their incomes more slowly.
2) Trade deficit: Foreign merchants accept USD as payment and then buy US treasuries with some percentage of the money. This essentially takes currency out of circulation in the domestic economy, reducing monetary velocity. The currency goes from the hands of consumers to merchants to the US government. The higher the trade deficit, the more cash is disappearing from the Main Street economy and going into treasuries.
3) Federal deficit: The 2020-2021 stimulus dwarfed the 2008-2009 stimulus, and it was also more directed toward consumers instead of banks. Banks hoarded the cash. Consumers blew the cash on housing and imports so quickly it caused severe shortages. In both cases, large amounts of money flowed from investors' hands into consumers' hands, but in the long run the flow reverses and consumers hand over their money to investors, who park it in treasuries. Once money is put into treasuries, it stops being used in transactions and might as well have stopped existing, as far as the real economy is concerned. These funds no longer contribute to transactions that aid price discovery.
These patterns can be expected to continue, and they are all disinflationary. This is why money supply does not equal deflation. This is why inflation was so low after the GFC. And this is why the stimulus of 2020-21 is rapidly leaking out of the real US economy.
Corporate De-LeveragingCorporate debt increased in early 2020 and then corporations briefly went into debt-reduction mode before continuing to add debt. The value of all nonfinancial corporate debt over the value of all corporate equity just reached all-time lows, beyond even the lows seen in early 2000. It is simultaneously true that corporations have record levels of debt while at the same time they are de-leveraging. Both statements represent slices of a growing pie. In terms of inflation, it does not appear corporations anticipate a prolonged period of high inflation, but they are probably better positioned than 10 or 20 years ago to handle such a contingency. Corporations as a whole are raising prices at the rate of inflation, while generally the interest costs on their debt is not increasing as quickly as their revenue. However if inflation falls and rates keep rising, that process will go in reverse.
Corp. Debt Source:
https://fred.stlouisfed.org/series/BCNSDODNSCorp. Debt / Equity Source:
https://fred.stlouisfed.org/series/NCBCMDPMVCE set to % change YoY
Government SpendingFederal expenditures are rapidly falling back toward a long-term trendline, despite the much-hyped infrastructure bill. This matters for monetary velocity because government spending accounts for about 38-40% of U.S. GDP. The rapid growth of 2020-21 occurred in part because governments spent a LOT of money, but that process is rapidly going into reverse. Government spending is falling, and that pulls down GDP and monetary velocity. Falling government spending increases the odds of recession and is disinflationary.
Fed Spending Source:
https://fred.stlouisfed.org/series/M318191Q027NBEA% of GDP Source:
https://tradingeconomics.com/united-states/government-spending-to-gdpYield CurveFlattened or inverted yield curves communicate that the bond markets expect a recession. Basically the bond markets are saying "I expect interest rates to be lower at some point in the near future, so I want to lock in today's rates on longer duration bonds before I lose the opportunity, as well as taking advantage of the appreciation of today's long-duration bonds when rates are cut." and everyone bids up the price for longer duration bonds while demand dries up for the shorter durations. An inversion of the yield for 10y and 2y bonds means a recession is very probable, and an inversion in the 10y and 3 month bond means it is certain and imminent. Right now we have a flat, but not inverted, yield curve, suggesting there is still some ambivalence in the bond market about whether a recession will occur or not. But another twist is that a rapid series of rate hikes are expected, so traders have to weigh their interests in staying short-duration so they can catch those higher rates against their interests in locking in rates before an expected recession. This suggests that market participants are assigning some probability - a decent amount actually - to the "transitory" scenario described above. If a sustained inversion happens, that means the transitory scenario has been dismissed.
Yield Curve Source:
https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202204Is There A "Neutral Rate"?Multiple Federal Reserve Presidents have made comments about the existence of a "neutral" range of interest rates that is neither stimulative nor constrictive, and their desire to reach this point within the next several months. In theory, when interest rates roughly equal the long-term inflation target, the economy is set for steady growth without the risk of policy errors causing unnecessary and destructive swings. This is purely an ideological construct - an untested and perhaps unfalsifiable hypothesis that may not hold true for all economies in all times. But it appears to be the consensus at the Fed so we'd better pay attention.
If the Fed considers this to be the optimal policy point for maximizing employment and price stability over time, they will gravitate toward this as a goal, and perhaps disregard contrary evidence. If we're heading toward "neutral", which is actually a long distance away from our current position, then maybe it doesn't matter if the stock market crashes, unemployment rises, bond losses sink banks, etc. The Fed could keep chugging along toward their self-established goal. Their guidance about letting inflation run hot for a while to offset earlier periods of low inflation could evolve into letting economic growth run slow for a while so that we can reach "neutral" and enjoy the long-run benefits of being there. Similarly, it could be they are wrong and the "neutral" rate of interest is a useless, constantly changing variable they'll never pin down with interest rate policy. If that's the case, we'll see a march-at-all-costs to 2.25%-2.5% followed by reluctance to adjust from there. This is what set off the 2018 correction and scary overnight markets activity, and it sounds like the Fed wants to give it another go.
Source for Mary Daly:
https://www.reuters.com/news/picture/raising-feds-policy-rate-to-25-by-end-of-idUSKCN2MC1CMSource for Thomas Barkin:
https://news.yahoo.com/feds-barkin-says-interest-rates-230514070.htmlSource for Charles Evans:
https://wdez.com/2022/04/20/feds-evans-repeats-view-he-sees-interest-rates-at-neutral-rate-by-year-end/
Stock Valuation at Various Interest Rates:The S&P500's current PE ratio is 21.8. This is lower than the average (24.7) for January 1 dates during the last 30 years but is considerably higher than other times when the 10 year treasury yield was near 2.9%, such as 2019 (PE 19.6, 10y 2.71%), 2014 (PE 18.15, 10y 2.86%), and 1956 (PE 12.12, 10y 2.9%). Perhaps a "neutral" interest rate will yield a long-term average PE ratio? The earnings yield of (1/22=) 4.54% implies that inflation will be low for the foreseeable future and that stocks will continue to earn a very modest risk premium of maybe 1.5% over 10y treasuries. Stock holders are voting for a transitory outcome.
PE Source:
https://www.multpl.com/s-p-500-pe-ratio/table/by-year10y Yields Source:
https://www.multpl.com/10-year-treasury-rate/table/by-yearA Caution on Inflation DogmatismIf you truly 100% believe high inflation is with us for the next couple of years, you should drop what you're doing, sell everything right now, and trade bear spreads on TLT. Collect 50% compound returns
per trade every 3 months or so for the rest of the year. If you're wrong, your losses will be 100%, but hey this strategy is for 100% true believers. Those who don't know how to trade options should buy SQQQ, a triple-inverse ETF, because growth stocks are going down as expectations change and we start to expect a Fed Funds Rate in the 4-6% range rather than the 2-3% range.
If you truly 100% believe inflation has peaked and is on its way down, then it's more complicated. Bond markets already assume inflation will peak soon and interest rate hikes will be limited, so there's no arbitrage opportunity. TLT won't necessarily go back up if the rate hikes stop at 2.25%, because it's already priced for that.
Stocks won't necessarily do well either, because the transitory scenario might or might not involve a recession. The Fed is likely to continue raising the rate target from their current 0.25% to at least 2.25% even if inflation starts falling precipitously later this year, and that will raise borrowing costs for corporations and their customers. Things that might work to "short inflation" while expecting a rise in interest rates would be to go long the US dollar (low inflation + high yields = attractive currency). Similarly it might be wise to establish a hedged position in stocks, because earnings growth might raise the E in "PE ratio" fairly quickly now that stocks have been discounted to match the future "neutral" rate of interest, and full employment has a way of supercharging earnings growth, while it lasts.
Either direction means massive losses if you're wrong. I don't think most people look at their portfolios this way, and say "Oh, looks like my portfolio is a big bet on transitory inflation and a soft landing." Similarly, I don't see the people most convinced that inflation is here to stay making the risky investments that would actually exploit that. There's a case to be made for a measured approach, accepting the possibility of being wrong, and waiting for clarity if necessary.
My Current EstimateJudging by breakevens and PE ratios, it appears that few people in the stock or bond markets are anticipating interest rates going higher than the Fed's 2.25%-2.5% "neutral" rate. This outcome would still include the 3 possibilities listed above: recession, transitory, or overreaction. However the folks calling for stagflation or more than one year of inflation >5% are in the minority (financial media is really playing up these scenarios, but the markets don't reflect them). This does not mean the doomsayers are wrong. Recall that prior to the GFC, the bond markets were apparently forecasting a soft landing. Just like today. The bond market was wrong as recently as early January, and it could come to the realization it was wrong again.
The only "good" scenario for long investors not in the accumulation phase would be the one subset of the transitory scenario where inflation falls from the April 2022 peak, rate hikes are stretched out longer than was anticipated in April 2022, unemployment stays low, and earnings growth makes up for PE shrinkage. There are a lot of variable that must go exactly right, but it's also the most probable outcome (out of several outcomes, so not saying much).
I think the Fed's credibility was shaken by the last 6 months' inflation numbers and all the "behind the curve" criticism. I also think all this "neutral rate" talk means we're heading to 2.25%-2.5% whether hell or high water. This drive toward an arbitrary goal will give the Fed another chance to get "behind the curve" as the economy goes into a post-stimulus sugar crash while they continue raising rates. So my forecast is the "overreaction" scenario. There will be a mild recession or a 2018-style crash that scares the Fed into rate cuts again.
Rate-hiking campaigns have historically been the most dangerous times to have market risk exposure. I could be wrong but when there are 8 ways to lose and one way to win, it's time for tightly-hedged conservative and cash-heavy portfolios. Even if we get the "transitory" scenario, and the Fed does everything right at just the right times to engineer a soft landing, it could all go to shite anyway when we discover that some financial institution is sitting on massive losses and can't pay counterparties.
Congrats to anyone who made it this far down the nerd hole. What data points, assumptions, or research am I missing?