Baker Market Update – wk211217

Our old friend William Shakespeare wrote that “a thing is neither good nor bad, but thinking makes it so.” Prices and yields in the bond market at any point in time are made up of expectations. The yield curve, for example, is flattening because of anticipatory pricing. It’s not looking at the inflation numbers that just came out. That’s ancient history. Instead, the market is looking well ahead into next year and assessing what Fed Chair Powell just told us quite clearly this week. That he’ll channel his “inner Paul Volker” and do whatever it takes to control inflation. Specifically, the Fed will accelerate the removal of stimulus by speeding up the taper and lay the groundwork for multiple fed funds rate hikes next year. Embracing that reality, short maturity US Treasury yields have naturally jumped… the 2yr yield is now .63%. What’s more telling, though, is that yields in the longer-end of the curve have come down sharply… the 10yr yield is now under 1.4%. This is the sort of yield curve flattening that often happens late in an economic cycle when fears of recession start to take hold. But there’s more to the story. This isn’t a normal economic cycle by any means. The recession was a self-imposed global shutdown one year ago, and the sharp snapback was fueled by enormous amounts of fiscal and monetary stimulus which is now fading away. And then there’s the problem of (so-far) persistent inflation.

Remember that a traditional inflationary impulse is driven by an overheating economy where everything is maxed out, hitting on all cylinders and strong demand is pulling up the general price level. That is not really what’s happening now. Instead, we’re dealing with “supply shock” inflation where COVID-induced shutdowns produce bottlenecks and sclerotic trade flows. Dock workers, truck drivers, processing personnel and other key points in the supply chain are working with reduced staffing and capacity, causing ripple effects throughout the system. Dusting off the old economics textbook, we see that the result is a sudden (leftward) shift in the supply curve and an upward shift in the general price level… a jump in inflation. So, the question becomes this: are rate hikes and tighter monetary policy the right medicine for “supply shock” inflation as is normally the case with “demand pull” inflation? Or might a higher cost of borrowing just exacerbate the supply chain disruptions? A point to ponder indeed.

Make no mistake, the Fed needs to stop pumping liquidity into the system. It’s caused unnecessary market distortions and pumped up an asset price bubble that may now be in the process of bursting. But the yield curve is suggesting to the Fed that they tread very carefully going forward. COVID has not gone away, and the knock-on effects render this situation real tricky for the central bank. Fingers are crossed.

The data released this week included another eye-opening jump in headline producer prices to 9.6% year-over-year. The core measure was a milder 7.7%. The core measure of Retail sales slipped -0.1% for the month, but the housing market continues to shine as existing home sales and building permits both exceeded expectations and prior month readings. Business inventories popped up 1.2% causing concern about an overhang if demand doesn’t keep pace. Next week is the pre-holiday week. Let’s all hope for nice gifts from Santa Claus.

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