Are Inflation Fears Justified?
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What You Missed: Long-term interest rates fell, and equities traded just shy of record levels as supply chain issues and fears of inflation permeated markets. The yield on the benchmark US 10-year note dipped to 1.56% from 1.64% a week ago. The real action appeared in shorter-term rates, like the 2,3, and 5-year Treasury yields, which continued to trend higher from last week. The price of a barrel of West Texas Intermediate crude oil rose to $83.40 from $82.70, as the US Dollar strengthened, and Gold weakened. Treasury yield volatility, a key driver of the cost of option-based interest rates derivatives like rate caps, launched higher to levels not seen since February.
BORROWER AND LENDER ALERT: LIBOR-indexed rate caps and swaps are an endangered species – are you ready?
If you’re a floating rate borrower or lender that has ignored the impending death of LIBOR, the Federal Reserve’s recommendation that bank’s not enter into any new LIBOR contracts after December 31, 2021 should wake you up to the issue quickly. While the deadlines and nuances of LIBOR’s transition to a new index may change, it’s time to get up to speed on how the event will impact: 1) new and existing loans and 2) new and existing rate caps and swaps.
This shift will impact you, perhaps negatively. Contact us for a discussion on how LIBOR’s transition impacts your specific situation, and what actions you should be taking now.
Delta variant, supply chain woes crimped Q3 growth. The economy shifted into a lower gear in Q3, growing at only a fraction of the pace of the first half of 2021. Gross domestic product (GDP) expanded a paltry 2% compared to the same quarter a year ago, down from a 6.7% annual rate in Q2. A sharp drop in auto industry output due to the shortage of semiconductors alone shaved about 2.5% from the topline figure. The data underscore how unprecedented supply constraints are holding back the economy. Understaffed and short of necessary materials, producers of goods are struggling to keep up with demand. Service providers, who face similar pressures, fared better than manufacturers during the quarter despite the pickup in infections.
What’s the biggest driver of America’s economic growth? The GDP numbers reflected a sharp slowdown in personal consumption, aka consumer spending. The spread of the Delta variant amid lingering supply chain bottlenecks helped slow the pace of growth of consumer spending significantly, to a 1.6% annual pace from 12% the prior quarter. Product shortages – primarily motor vehicles and parts – took a big bite of out spending on goods in particular (-9.2% vs. 13.0%). However, spending on services were dented only marginally (7.9% vs. 11.5% prior).
Our take: The slowdown doesn’t surprise us, given that supply-chain bottlenecks are crimping consumer spending on goods, stalling investment, and slowing trade flows. While supply chain challenges are expected to linger well into 2022, subsiding Covid-19 infections and consumer’s elevated savings should support stronger spending, particularly on services, in Q4. What does it mean for interest rates? Well, the inconsistent pace of economic growth last quarter tells us that financial markets – who are expecting two quarter-point rate hikes form the Fed next year – may be out over their skis a bit. Will the Fed hike aggressively amid a bumpy road toward economic recovery? We doubt it.
The inflation boogey-man is seemingly everywhere – is the fear justified? The latest gauge of inflation, the core personal consumption expenditures price index (PCE), the Fed’s favorite inflation gauge, remained elevated, growing an annualized 4.5% last quarter after a 6.1% jump in the prior three months. Elsewhere, an surprise spike in the employment cost index (ECI), a wage gauge favored by the Fed, suggests that the pace of wage growth has picked up briskly. Both the PCE and ECI readings will give the Fed some ammunition as they’ll likely soon make the case for more inflation urgency.
These latest readings have also caused a rift between bond traders and economists, whose Fed rate hike expectations have grown further apart. In short, traders believe the Fed will hike rates twice next year while economists believe liftoff won’t begin until 2023. Who’s right? We won’t know until mid to late next year, when the pandemic-ridden, temporary factors that drove up inflation readings this year will have dissipated, and the Fed will have mostly completed its taper.
The Fed’s own models suggest it will likely tighten earlier and faster next year if core PCE inflation exceeds 3.5% (it’s 4.5% now), and “full employment” is reached, with the unemployment rate at or below 4% (it’s 4.8% now). While one of the two pieces driving the Fed’s calculus – the improvement in the jobs picture – is tough to map, we expect that inflation readings, the other piece, could rise higher if:
- Supply-chain bottlenecks persist. If supply problems don’t gradually improve as we and others assume, goods inflation alone could provide a tipping point for inflation increasing and staying high. Goods inflation would only have to rise by a small amount and stay there to manifest high and lasting prices and cause the Fed to pull the trigger earlier than late 2022.
- Prices for services jumps higher. Supply chain restraints have pushed goods prices above the pre-pandemic level, while services prices have remained below their pre-pandemic trend. As we said above, with the delta strain in retreat, the pattern could reverse next year. Should demand for services rise dramatically – specifically in categories sensitive to post-pandemic reopening – transportation, recreation, and education services – it could spur the Fed to act earlier than we expect.
ISDA’s new IBOR fallbacks have come into effect: Are you a borrower? Do you own an interest rate cap or have an interest rate swap? It’s critical that you understand the IBOR fallbacks to avoid potentially negative financial consequences down the road. Get educated here: The ISDA IBOR Fallback Protocol and What it Means for You
What to Watch This Week: It’s jobs week and Fed week. This dynamic duo of events will take center stage and cast all other data and events to the shadows. Let’s peek at what’s in store.
First up, Wednesday’s Fed meeting, where Chair Jerome Powell & Co. are expected to announce the start of tapering; the key details on the pace, timing, and composition of its plan to reduce its $120 billion per month in bond purchases. We expect tapering will begin in mid-December, with the Fed reducing its bond purchases by $10b in Treasuries, and $5b in mortgage-backed securities per month, completing the taper in June 2022. However, the Fed will go out of its way to note that it’s not on a pre-set tapering course. While this will be a big announcement and change of course for the Fed, the market now expects it, and thus we doubt we’ll see much movement in rates from the announcement.
The most important aspect of the Fed meeting? Any signals the Fed gives about when rate hikes might follow its taper actions. Despite price and wage inflation both running hot, the Fed won’t give a specific time frame about when it could hike. Rather, we expect it to state more outcome-dependent language, like “we’ll hike when the unemployment picture improves”, keeping any numerical thresholds vague and thereby preserving its option to hike rates as soon as the taper is complete – around the middle of next year – should the jobs or inflation picture require it. To put our own spin on it, we suspect the Fed will hike rates if core PCE inflation averages above 3.5% and the unemployment rate falls below 4% in 1H 2022. If it happens at all next year, it likely won’t be until late Q3 or early Q4.
Second, Friday’s jobs report. Following Wednesday’s Fed announcement, jobs data for October (ADP on Wednesday, nonfarm payrolls on Friday) will signal whether the Fed’s read of labor-market progress toward its maximum- employment goal was correct. With recent job-creation readings faltering, we anticipate that a strong jobs recovery won’t happen until early next year, when concerns about Covid truly subside with wider availability of boosters and shots for children, and households spend down the excess savings they accumulated from pandemic stimulus programs. Regardless of the timing, given the current elevated inflation readings, a faster recovery in jobs would pull forward the first-rate hike to mid-2022. We’re not there yet.
Other data releases during the week will provide more clues to whether inflation will continue to run hot: ISM manufacturing (Monday) and vehicle sales (Tuesday) will likely show supply-chain bottlenecks have intensified. Unit labor costs (Thursday), which measures compensation per worker adjusted for productivity, will likely show a spike.
Big Picture: This week’s Fed meeting, and the heated debate on when the first post-Covid rate hike will happen, brings the Fed’s dot plot into view. If you’ve never heard of it, the dot plot is a chart routinely published by the Fed that summarizes the rate hike outlook of its twelve voting members, where each dot on the chart represents the interest rate forecasted by each member. Many in financial markets treat the dot plot as a crystal ball of sorts for predicting when the Fed will hike rates. Unfortunately, as we’ve said many times before, don’t buy into the dot plot hype. Here’s why:
The dot plot’s track record at forecasting rates correctly is terrible. It has consistently overestimated where the fed funds rate – the rate the Fed hikes or cuts – would be over much of the past decade. Basically, Fed committee members have routinely overestimated future inflation.
Below is a chart showing what the dot plot was forecasting at varying times (multi-colored lines) versus how the Fed Funds rate (in red) actually moved over time:
Source: Bloomberg Professional
Current Select Interest Rates:
Rate Cap & Swap Pricing:
Source: Bloomberg Professional
Source: Bloomberg Professional