April 25, 2024
Dimitri Triantafyllides, CFA
(704)968-9074
A Hamburger Today for Payment on Tuesday
Source: https://www.soundthemidnightcry.com/.a/6a00d83453e66269e201b7c7c5a9a0970b-pi
Wimpy, the always hungry character in the Popeye comic strip must have had great connections with the financiers on Wall Street or the Federal Reserve. His strategy of asking to get fed today, but paying for it in the future has been a brilliant strategy as prices of goods and services continue to increase at rate not seen since the 1970s. If Wimpy has been eating Big Macs from McDonalds, he could pay today for three Big Macs consumed in the 1980s with money that would only buy one today.
Price of Big Mac
Source: https://moneynotmoney.com/historical-price-of-big-mac-in-united-states/
What Wimpy figured out long ago is that in a world of inflation, money is better spent today rather than tomorrow, when its purchasing power is lower. Of course he was going one step further, consuming today and paying the consumption back with “cheaper” dollars later. Either way, in a world of inflation, consumption and borrowing are encouraged, whereas saving is discouraged.
In its attempt to no turn all of us into a Wimpy, the Federal Reserve has been increasing the cost of money leading to higher interest rates across maturities, but with short term rates higher than long term rates. The challenge the Federal Reserve is currently facing is deciding whether current rates have been sufficiently high for a sufficiently long period of time to “de-Wimpify” the economy.
Source: wsj.com
In the first couple of months of the year, the Federal Reserve tried to explain away persistent inflation as “seasonal”, probably because it had already used “transitory” too much and too prematurely as post-lockdown inflation was rearing its ugly head. Of course, not wanting to declare that it has been behind the eight ball in taming inflation, the Fed focuses on “inflation expectations” rather than actual inflation. Its key point is that “inflation expectations remain anchored”. Not to break it to the Fed, but actual consumers must pay for goods and services for prices posted, not for prices that would have been once expectations are normalized. While inflation may be “down” from the high levels experienced in mid-2022, now even inflation expectations have jumped and have only recently fallen back to 3%, a numbers still well above the Fed’s inflation target of 2% (see chart, next page).
Inflation Expectations (2007-Current)
Source: https://fred.stlouisfed.org/series/MICH
Furthermore, even “lower inflation” is still being tacked on to prior prices increases, leading to the compounding debasement of purchasing power (see CPI inflation chart). Since the Pandemic, prices on everything are up an aggregate 20%, and even if the growth rate has slowed down, they’re only going up from here. No wonder Wimpy is hungry today.
Consumer Price Index (2007-Current)
Source: https://fred.stlouisfed.org/series/CPILFESL
Where do long term rates go from here? While the Federal Reserve is keen on managing short term rates with an eye toward an eventual initiation of rate decreases, long term interest rates and their outlook is harder to gauge. A strong US dollar is attracting capital, including capital into US Treasurys. This counters the upward pressure on yields from the increase in expected issuance of Treasurys to fund our large US Federal Budget Deficits, as well as the modest reduction of the Federal Reserve’s holdings of US Treasurys and Mortgage Backed Securities as they mature. On several occasions, the Fed seems to have intimated that slowing the pace of such “runoff” could allow it to help support Treasury prices, were long term rates to increase dramatically.
Since the Qualitative Easing strategy deployed by the Fed during and after the 2008 Financial Crisis (the buying of US Treasurys while crediting banks’ reserves – a circuitous way to “print money”), we have yet to experience a yield curve left to the animal spirits of the free market. How well the Fed navigates the current headwinds, is beyond our ability to speculate. Nonetheless, we do believe that an eventual economic slowdown (where even Wimpy starts cutting back on his hamburger consumption) will help place a limit on longer term US Treasury yields. Whether that is at 4.5% for the 10 Year Note or 5%, is hard to tell, but somewhere in that range we believe there will be value in longer dated securities.
Given the current shape of the yield curve (refer back to the Yield Curve chart), the easy investment is to keep rolling short term investments, actually earning above longer-term rates. Yet, for anyone familiar with the wonky “implied forward rate curve” the solution is not that easy. To put it simply, yes, one can buy a one-year Treasury Note and earn 5.2%, well above the 4.6% offered by the 5-10 year maturities. But, in a year from now, when the one year Treasury matures, rates could be a lot lower. At that point, having locked in high rate for longer, may have been the better strategy. The current “implied forward rate curve” looks at the implied short term rates in the future, which currently are still somewhat elevated. Only if the one-year rate is 4.8% or higher a year from now, should one stick with one-year Treasuries today. The better trade in our opinion, is to use the recent increase in longer term rates to lock in rates today that may not be as high as the business cycle takes its course.
At some point the economy will slow down, and Wimpy will be defeated. Even with say inflation stabilizing at 3%, and long term GDP growth settles at 1.5% or lower, rates of 4.5% may prove quite attractive in a slowing economy. And even if inflation persists, the Fed appear, in our opinion, willing and able to add liquidity at the long end, pushing long term rates once again. In summary, we believe that the economy is not quite read to rollover into a recession, inflation is stickier than the Fed wishes, the dollar is likely to remain in demand, equities are fairly valued, and longer-term fixed income investments are beginning to look attractive.
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