As a reminder, since the early 1980’s each rate hiking cycle ended below the peak of the prior one. In Q4 2018 the Fed stopped when the fed funds rate got to 2.25-2.5%. So, the rather quick pace and much higher level of rate hikes currently priced in, 50bps at each of the next three meeting, an ultimate near 3.5% fed funds rate by next summer and an annualized pace of QT of $1.14 Trillion, would be by far the most aggressive tightening stance seen in a post Volcker world if the Fed actually follows through. And it won’t just happen in a vacuum in order to tame inflation. Decades of easy money have medicated an entire economy on a low cost of capital and given markets reason to achieve ever higher multiples and ever tighter credit spreads. It is why the investing world has changed this year and why the coming few years will be quite different than the previous. While investing has seemed ‘easy’, it never is and now is ever more difficult and challenging. With the S&P 500 still trading at 19x earnings, the NASDAQ by 27x, the Bloomberg high yield index spread to Treasuries of 344 bps vs the 10 yr average of 435 bps and 20 yr average of 510 bps, there is just no room for error here. Own short term treasuries at current yields, avoid long duration. Own dividend paying value stocks. Own commodity stocks still, especially energy and precious metals. Own the local currency bonds of emerging market commodity currencies that have great yields. And don’t be afraid to buy cheap stocks in Asia and Europe.
And keep in mind that trillions of dollars of loans are LIBOR/SOFR based. If you didn’t see from yesterday the WSJ article titled “Floating rate debt bits corporate loans,” the article says “The benchmark rates that most leveraged loans are priced off are expected to rise to around 3% in the next 12 months, from about .50% now, according to Citigroup research. That equates to a $45 billion interest expense increase on the loans that were issued in 2021 alone, according to Dealogic data…Companies are more exposed than during the previous LBO boom in 2007 because most loan investors no longer require them to purchase derivatives to hedge against rising rates” according to a Citi strategist. I mentioned a few months ago the retail money that flooded into floating rate funds/etf’s hoping to benefit from rising short term rates without doing the credit work on the companies that have this floating rate debt.
Fed Funds Rate
Notwithstanding all the tightening expected to come, it has done absolutely nothing to quell inflation expectations in the TIPS market. Yesterday the 10 yr inflation breakeven closed above 3% for the very first time at 3.04%, dating back to 1998. The 5 yr yesterday closed at 3.63%, matching a high. Also of note, the 5 yr 5 yr inflation rate, so yr 6 thru 10, is at the highest since 2014 at 2.63%.
10 yr Inflation Breakeven
Here is the front page of the new Economist but unfortunately readers will only think the Fed’s failure just occurred because of the current bout of inflation but their failures have been building for decades and higher inflation is only the kryptonite that has exposed them.
What the Fed has wrought over the decades by playing God over the most important price in capitalism, the cost of capital:
1)With the encouragement of always being there to bail out situations of financial distress, like LTCM and quick with the trigger on rate cuts such as also after the 1997 Asian crisis, a generation of moral hazard was born.
2)Via ever falling interest rates, most of which were pushed lower by the Fed, they encouraged a legacy of ever rising borrowing and debt.
3)Housing has become more and more unaffordable over the past few decades.
4)The US financial system was on the cusp of collapse in 2007-2008, encouraged in the years prior to borrow and speculate in a search for yield in response to artificially placed interest rates.
5)Just a few years prior to that housing boom and bust, Greenspan egged on the tech bubble, which was epic for those that didn’t see it.
6)Congress (both parties) got the green light via the low cost of funding to take us to $30 Trillion relative to a $24 Trillion economy.
7)All resulting in financial fragility where modest changes in interest rates now have a pronounced impact on everything and the jump in consumer price inflation (following so many years of asset price inflation) now puts the entire system to a major test.
Moving on, at least from the perspective of Auto Nation, higher interest rates and record high prices still hasn’t impacted the consumer. In yesterday’s earnings call they said “consumer demand for personal vehicle ownership remained strong across both our new and our used channels…we have not seen any reduction in lieu of demand for new vehicles or really any perceivable segments shifting as a result of current economic conditions…And our used car performance reflected good volume on a same store basis and the continue expansion of our AutoNation USA business.” At least not yet impacted but the rubber is most likely going to meet the road, no pun intended, if financing costs continue higher as well as car prices.
This is what PPG Industries, the large paint company (among other things), said in its earnings release, “Given higher global energy prices, we are implementing further selling price increases in all businesses, and our commercial processes are enabling closer to real time pricing relative to inflation.”
So yes, the current rate of inflation has likely peaked but I’ll argue AGAIN that it will remain very elevated still.
Japan reported its March CPI and it will be the last month that includes the sharp drop in cell phone fees. The core/core rate, ex both food and energy, fell .7% y/o/y as expected. The rate just ex food was up .8% and will likely print up 2% in April. While in line, the 10 yr inflation breakeven in Japan rose to the highest since 2015 at .93%, up 3 bps. The 10 yr JGB held at .25% with the BoJ buying what they can. The yen is flat at just off its 20 yr low.
Ahead of the US manufacturing and services April PMI today, Japan and Australia saw their PMI’s higher m/o/m. The Eurozone saw its manufacturing PMI slip modestly m/o/m but offset by a rise in services. Markit said “April saw a two speed eurozone economy. Manufacturing came close to stalling due to ongoing supply constraints, rising prices and signs of spending being hit by risk aversion due to the war. However, April saw manufacturers suffer due to a shift in demand from goods to services amid looser pandemic restrictions, most notably via a record surge in spending on activities such as travel and recreation.”
On pricing, “Common across both sectors, however, was a further surge in cost pressures, driven by soaring energy and raw material costs, as well as rising wages. Average prices charged for goods and services rose at an unprecedented rate in April as these higher costs were passed on to customers, sending a worrying signal that inflationary pressures continue to build.”
The composite PMI in the UK fell to 57.6 from 60.9 with manufacturing little changed and services falling by 4.3 pts m/o/m. The fall in services seems due to rising inflation. Markit said “High prices and the associated rising cost of living were often cited as a principal cause of lower demand, with covid also continuing to affect many businesses. Brexit and transport delays were seen as having further impeded export sales, while the Ukraine war and Russian sanctions also led to lost overseas trade. Concerns over the worsening inflation picture are meanwhile flamed by another near record leap in firms costs.”
There was also a greater than expected decline in UK retail sales for the same higher cost of living reasons and the pound is breaking down below $1.30 in response to the lowest level since November 2020.
Bottom line to the European data, I would not be surprised if the recession begins in either Q2 or Q3.