Inflation and Inversion
With inflation pushing the Fed to hike rates, is the bond market indicating a potentially hard landing?Download PDF
On April 11, 2022, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on the market performance, the Fed’s moves to combat inflation, inverted yield curves, consumer behavior and opportunities in fixed income.
The first quarter was tough for most markets. How does the first quarter sell-off leave investors for the balance of 2022?
Yes, the first quarter was very tough. The S&P 500 Index was down 4.6%. Now, that’s after a slight rebound in March when it was up just under 4%. So, January and February were not kind. The NASDAQ-heavy Russell 1000 Growth Index was up about 4% in March, but still ended the quarter down 9%. So again, tech has been getting hit.
But hands down, the story of the first quarter were the fixed-income markets. The Bloomberg Aggregate Bond Index (the Agg) was down almost 3% in March, which that month alone would represent one of the worst years for fixed income. And for the year, it’s down almost 6%, and the rout has continued in the first week of April.
High yield was off 1% in March and down almost 5% for the year. And floating-rate loans were up four basis points in March and, for the year, off 10 basis points. So that asset class has held.
As of today, we’re setting up for probably the worst bond year since the index started tracking—unless something breaks, and you start to see rates decline. The fortunate part is yields are higher. High yield right now crossed back over 6% in yield-to-worst, with BB credits yielding over 5%. For investment-grade U.S. credit, yields were a little over 3.5% with BBBs yielding almost 4%. We are returning to what some people would call normalization, but others could call it just an opportunity.
Let’s turn to inflation. Are you expecting it to remain higher for longer?
I would say, “Elevated for longer.” There are two elements of inflation? You have the price increases, which, in my opinion, will stay increased for longer. And then there’s the rate of inflation. My expectation is still that we start to see that decelerate in the second half of this year.
We are beginning to see some signs of inflation coming off highs. When you look at energy futures and at shipping rates, excluding fuel, they are coming off their highs. We may finally be seeing some demand destruction due to these higher prices.
The market has quickly adjusted to the Fed’s messaging on meeting the challenge of inflation with rate hikes, and we sit today with an inverted yield curve. When you look at the 2-year and 10-year Treasury yields, how should we interpret this market signal?
I want to start first with the Fed, and this is a very recent development. The Federal Open Market Committee (FOMC) minutes from its March meeting were recently released. Judging by those, I’d say in the summer the Fed is going to be very aggressive, and that has elevated rates across the curve.
Let’s talk short-term rates. A 50-basis-points rate raise by the Fed is on the table for the May meeting, and the Fed neutral is probably in the mid-twos. So, let’s say 2.25 to 2.5%. That would be eight moves from here. And the term they used in the minutes was moving “expeditiously”. That tells me the Fed’s going to move to that 2.25, 2.5% quicker than most people originally thought.
But the Fed also put on the table expectations for a tighter monetary policy. When you think of 2.25, 2.5% being considered neutral, and the Fed is saying, “Hey, we could make it tighter,” then it could very well be that short-term rates move beyond. So that’s one thing that came out of the minutes.
Now on the long-term side, balance-sheet reduction is the focus, which you’ll hear as quantitative tightening or QT. In the minutes, the Fed said QT was expected to begin in May. Base case is the ramp up is going to take three months, and it’s going to be $95 billion a month—$60 billion in Treasury, and $35 billion in mortgage-backed securities.
The market is now discounting an aggressively tighter monetary policy. You have inflation expectations that are being discounted to last longer. So, rates are elevating across the curve, and you’re seeing this market weakness.
As it relates to curve inversion, on the short end, the Fed controls that by overnight rates, so that has aggressively moved in line. The long-end is Fed-influenced, with the balance sheet being the primary influencing mechanism. In my opinion, if at any time the Fed changes their short-term result, they could get to a steeper curve. If the Fed came out and said, “Hey, we’re stopping at 2%” and then rates hold, you have a steeper curve, and the inversion can be handled.
But when I think about it, if inflation starts to wane and the economy is functioning with short-term rates in the mid-twos, the Fed can say, “Hey, we’re going to neutral, and we should have a healthy curve.” I think the shock is really if inflation accelerates from here, the Fed has to become even more hawkish. They may end up pushing to an inverted curve, and hence you probably have a recession. The pivot point to me is if inflation accelerates or decelerates. And that will dictate if the inversion really does signal a recession.
Besides 2-year and 10-year Treasury yields, is there another yield curve signal that you would prefer?
The twos-tens has been traditional, but that’s factoring in 11, 12, 13 hikes, hence you get that short-term indicator. I think it’s okay to look inside the two-year as well. We’ve seen some research folks indicate three months and six months as indicators, and the reason is because there’s going to be so much data coming in over the next six to 12 months around the pace of inflation, obviously impacts from COVID, impacts from the invasion of Ukraine that will affect, on the margin, Fed rates.
I think it’s fair to say that the two-year is probably not the best indicator because of the amount of data that is going to be coming in that could influence the direction of short-term rates. So perhaps maybe the six month, maybe the one year. Two-to-10 is really flat. Watch the 10-year though. I believe the 10-year is going to dictate more truth about the economy than where the Fed is.
If we look at sectors of the economy and the consumer behavior, where are you seeing interesting trends?
I’ll start broad based, and these are changes over three years based on Bank of America daily credit-card spending. We’re going back to pre-COVID to early April of 2019. In general, total card spend is up about 22% compared to that time period. That’s pretty healthy.
When you look through to the sub-sectors, the clear outperformers over the past three years were online retail (up 80%), online electronics (up 40 to 50%), gasoline (up 40%) and furniture (up 30%). Then you get to general retail (20 to 30%), and that’s excluding auto. Restaurants are up over 25%. All those elements have done well.
The underperformers, as expected, were airlines (up 8%). Entertainment’s been pretty flat. Department stores are down, and clothing off about 15%, which if you’re going into the office less, you’re probably not buying as many clothes. Those last two declines, to me, are really more secular in nature.
One of the things that I found interesting Bank of America broke down the gasoline spend between lower-income and higher-income households. B of A is defining lower income as less than $50,000. Gas now represents about 9% of spending for those lower-income households, forcing less spending on groceries, clothing and discretionary items. For higher income, which B of A defines as over $125,000, gas is about 5% of that spend per year. What they’re seeing is lower spending on discretionary, particularly airlines, online spending and lodging.
Here’s another statistic of interest. In states that are heavy energy producers, which would be categorized as Texas north through the Dakotas, spending is up about 26%. But in states with high gas prices, which is predominantly the western U.S., spending is up about 20%, and that’s excluding energy.
Changing gears now, for well over a year, we have pointed out the potential advantages of floating-rate loans. How is that opportunity evolving based on our current expectations?
I have to say it’s been more impactful than I would’ve guessed and not necessarily due to how stable floating-rate loans have been over the past year-and-a-half. It’s really about how far rates have gone and the impact on fixed rate. Take 2021, the Agg Index was down 1.5%, and floating-rate loans were up 5.5%. That’s an almost a 700-basis-point delta. This year, floating-rate loans are flat, and the Agg is down 6%. In the past 15 months or so, the difference between floating-rate loans and fixed-rate instruments is close to 1,300 basis points. That’s a significant delta.
We still have a strong consumer, strong earnings, strong job market, healthy savings, and low defaults. It’s a healthy corporate sector. However, I believe what’s on now on heels of floating-rate loans is that fixed rate is becoming more interesting. To me, what has kept floating-rate more comfortable is the adjustments in the forward curve. Today LIBOR or SOFR is below 50 basis points. However, if you start to discount in the forward curve where you have an aggressive Fed, then the coupon and loans may get pretty attractive. I still view floating-rate loans as a defensive trade against inflation. I think it’s even more attractive as the market is adjusting to a more aggressive Fed.
Given that, fixed rate is getting interesting. Real GDP is slowing this year. And in 2023, the Fed is expected to continue to tighten conditions. Nominal GDP is expected to grow at a slower pace, and yields are climbing. And again, it’s all on the margin, right? I would prefer to see some stabilization and decline in inflation because that’ll lead to stabilization of Fed policy. I want to see that before I get really comfortable with duration. I’m not there yet.
Are there other parts of the fixed-income market that look attractive at the present, given the big selloff and jump in rates?
On the margin I’d say interesting, not yet attractive. Again, I want to see that stabilization in either inflation or yield levels before I say attractive.
High-grade credit coming up on 4% is interesting. High yield sitting at 6%, not bad. Given expectations for a slowing economy over the next two years and tightening monetary conditions, if you’d ask somebody, “What are your return expectations for equities over the next three to four years?” I think if the answer is anything less than 8%, then you should absolutely look at high yield because your yield-to-worst right now is 6%. Yield-to-worst is your best proxy for three-year returns. So, if an investor told me, “I think equities will return 6 to 7% over the next three years,” I’d say, “Well, then you might want to consider high yield as something to significantly reduce your risk and give you that coupon.”
Now it’s time for our traditional lightning round. As a reminder, I’ll give you a word or short phrase, you tell me the first thing that comes to your mind. Are you ready?
Number of total rate hikes in 2022 and rate target from the Fed.
Will the 3-month 10-year be inverted at yearend?
I’m a no.
Is inflation peaking?
The rate of inflation, I believe it is.
What are the chances the EU boycotts Russian energy?
I think that’s optics. There’s going to be a work-around.
The price of a gallon of gas on July 4? Currently, the national average is $4.10.
That’s a great question. I’m $3.85. If I believe inflation’s peaking, then I should honor that.
What key economic indicator are you most closely looking at right now?
The Producer Price Index (PPI), which serves as a leading indicator for the Consumer Price Index or CPI, a measure closely watched by the Fed.
The two best things that could happen to the economy?
Putin is no longer Putin, and COVID is no longer COVID.
What about the two worst things?
Putin is Putin, and COVID is COVID.
Is the economy over COVID?
I think consumers are; I don’t think supply chains are.
And lastly, Elon Musk buying a 9% share in Twitter.
Oh, Elon’s brain is a maze. So, he probably sees some opportunities, or it may be just boredom. Tough to know.
Dominic, I imagine many readers took heart your reflection last month about being aware of the future, but not suffering in advance. Do you have a thought today that you’re reflecting on?
We spend a lot of time thinking about financial investing, and I would say make sure you allocate the proper time to invest in the non-financial elements in your life—your health, your mind, your relationships, and your passions.
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Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed Income Funds. The views in this commentary are as of April 11, 2022 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.
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