Interest rates continued the upward climb that began last summer. Starting at 0.5%, the 10-year US Treasury reached 0.9% at year-end and closed last quarter at 1.7%. Such movement reflects expectations of a rapidly reopening economy on the heels of COVID-19 vaccine development, approval and distribution. The Fed doesn’t seem too concerned.
The more important questions for future returns revolve around inflation. A surge in year-over-year inflation is expected in the second quarter due to a sharp dip in prices as quarantines took over one year ago. The Fed’s messaging reflects comfort with inflation in the short run and their view that inflation will burn itself out. For now fixed income markets are on-board, with futures markets expecting 2.7% inflation over the next two years, and 2.4% inflation over the next ten.
But what if the inflation bump is much longer than a short-term blip associated with reopening economy? The Consumer Price Index (CPI) through February was 1.7%, the most recent annualized six months is 2.8% and the most recent annualized three months is 3.6%. Signs of pressure are growing from a variety of sources. Consider the following.
A synchronized global recovery this year will place pressure on input costs. The Producer Price index (PPI), which reflects manufacturing input costs, is up 4.2%, the highest increase since 2011. Commodity prices are all up over the last year, the majority showing double-digit increases, and some energy commodities have increased more than 100%. For reasons of competitive pressures, higher shipping costs and national rivalry, companies and governments are moving towards domestic supply chains, even if that leads to higher costs. Chinese manufacturers are raising prices to account for higher input costs too. A stronger dollar mitigates higher import costs somewhat, but that is not a long-term solution.
To fight the war against COVID-19, Congress recently passed the third major stimulus bill in 12 months and is already talking about many trillions more for infrastructure, education and anti-poverty measures. COVID-related stimulus exceeds $5 trillion+, which is more than the costs associated with WWII ($4.8 trillion) and Vietnam ($1.0 trillion), expressed in 2020 dollars. Both of these events preceded inflationary spikes in the U.S. and associated spending was partially to blame.
The Congressional Budget Office estimated the Consolidated Appropriations Act passed in December, 2020 would reduce the gap between actual and potential economic output to $250 billion annually. The recently passed $1.9 billion American Rescue Plan will more than fill that gap, stimulating more demand than our economy can reasonably supply. We have too much money chasing too few goods.
Simultaneously, the Fed is focused more on job creation, stressing that low rates helps society’s marginalized the most. They have made it clear they will raise rates, not based on forecasted inflation, but reported inflation instead. Further, they are comfortable letting inflation run a high for a while since it has run below their target for so long.
Markets, however, are made up of forward-looking investors. Rising rates experienced this quarter are a reflection of their inflation concerns accompanying a reopening economy with so much new money available to spend. Investors are not waiting for inflation to show up in the data. Ironically, if higher inflation leads to tighter monetary conditions that results in higher unemployment, it is the marginalized that will suffer most.