Weekly Commentary: Under Fire

The week had an ominous feel. Ten-year Treasury yields dropped another seven bps to 1.29% - completely disregarding much stronger-than-expected reports on consumer and producer prices, along with inflation expectations.  German bund yields fell another six bps to a three-month low negative 0.35%. Equities were down for the week in Europe, but the notable equities weakness was posted by the broader U.S. market. The Midcaps dropped 3.3%, and the small cap Russell 2000 sank 5.1%. Risk aversion typically leaves its initial mark at the “Periphery.”

Silhouette, Fall, Falling, Collapsing


Treasury market notwithstanding, inflation has become a problem in more ways than one. Consumer Prices (CPI) jumped 0.9% in June, versus expectations of a 0.5% increase. Year-over-year CPI was up 5.4% (expectations 4.9%), the strongest jump since 2008. And for analysts with issues with year-over-year “base-effects”, consumer inflation was up 3.3% in only five months. Core CPI also gained 0.9% for the month, with a 4.5% y-o-y increase. Producer Prices rose a data series record 7.3% y-o-y. Import Prices jumped 1% for the month and 11.2% y-o-y. University of Michigan one-year Inflation Expectations rose to 4.8%, the high since the summer of 2008. Also, at 4.8%, the New York Fed’s survey of one-year inflation expectations jumped to the highest level in data back to 2013.

To this point, inflation has not been an issue for the markets. It has become a problem for millions of Americans. For the institution of the Federal Reserve, it’s a metastasizing malignancy.

I understand why each Fed official sticks tightly with the party line “inflation will be transitory.” They don’t want to rattle the markets with thoughts of a traditional tightening cycle. And I think I understand why they adopted their framework aiming for a period of above target inflation – and why they swore off responding to incipient inflationary pressures. Again, they sought to retain flexibility to maintain highly accommodative monetary policy, ensuring financial conditions would remain exceptionally loose (and markets high).

Now they’re in a pickle. Things are not proceeding according to plan, and many, including Washington politicians, have serious issues and questions. For starters, what does the Fed mean by transitory? When would heightened inflationary pressures move beyond transitory? And, regarding the new inflation framework, how much beyond target would be too much? And for how long? The Fed does not have answers for some pretty fundamental questions.

Our central bank is trudging into a mine field. I’m concerned about climate change, inequality and racial justice. But those are not within the Fed’s purview. The Federal Reserve has an incredibly important role in our society – to maintain sound money and price stability. It’s an exceptionally challenging responsibility. It’s no exaggeration to suggest the consequences of failure are calamity. The world was in the throes of momentous change, while finance was evolving. They needed to be razor fixated on financial stability, but lost their focus.

Once our “activist” central bank ventured into bolstering the securities markets and using unconventional measures to reflate the economy, it was going to be extremely difficult to refrain from venturing into all types of measures to support various groups and causes. Add QE to the toolkit, and it will become virtually impossible not to be compelled to allocate Fed money to satisfy political interests. After buying Trillions of Treasuries, supporting markets in MBS, muni bonds, corporate debt, ETFs and stocks was going to be inescapable.

The Fed basically risked everything. They thought the changing world meant no more worries of surging inflation and actual tightening measures. Keeping the markets elevated became their unstated priority. But they’re now on the wrong side of a losing bet, a predicament that became increasingly clear this week with Chair Powell’s beltway testimony. The Fed, understandably, is Under Fire for surging inflation.

The institution and its beloved QE have also ensured it today sits right in the middle of an epic political battle. Fiscal conservatism has awakened from a prolonged deep coma. The Republicans have a cause that will increasingly resonate. They see Fed QE financing the liberal agenda and inflation provides the Republicans with additional impetus to confront Federal Reserve policies and doctrine.

The Fed risked their credibility and independence. One can see their credibility erode in real time. Before this is over, their institutional independence will also be in tatters. This is especially distressing considering the collapsing trust in many of our principal institutions.

For posterity…

Pennsylvania Senator Pat Toomey: “The Fed's policy is especially troubling because the warning siren for problematic inflation is getting louder. Inflation is here, and it’s more severe than most, including the Fed itself, expected. And it is more than offsetting the wage gains, so leaving workers worse off despite their nominal wage increases.

For the third month in a row, the Consumer Price Index was higher than expectations. Core CPI… was up 4.5% in June; the highest reading in almost 30 years. And to be clear, this is beyond the so-called base effects. The two-year change in Core CPI was at a 25-year-high. And with housing prices absolutely soaring in many places to completely unaffordable levels, I have to ask why on Earth is the Fed still buying $40 billion in mortgage-backed bonds each month?

Now, the Fed assures us that this inflation is transitory, but its inflation projections over the last year have not inspired confidence. Last June, the Fed projected that PCE… would be 1.6% for the 12 months ending 2021. Then in the December the Fed raised that figure up to 1.8%. And how the Fed's most recent PCE forecast for 2021 year-end is 3.4%, more than double what the Fed thought inflation would be a year ago… I'm very concerned that the Fed's current paradigm almost guarantees that it will be behind the curve in inflation does become problematic and persistent, for several reasons.

First..., the Fed has consistently and systematically underestimated inflation over the last year. Second, the Fed has announced it will allow inflation to run above its 2% target level. Well, it’s already well above 2%. And third, the Fed insists that the inflation we’re experiencing now is transitory, despite the fact that recent unprecedented monetary accommodation has certainly driven the inflation that we’re witnessing. And since the Fed has proven unable to forecast the level of inflation, why should we be confident that the Fed can forecast the duration of inflation…?”

The Fed's current monetary approach seems based on the premise that it needs to prioritize maximum employment over price stability… And when the Fed subordinates its price stability mandate to try to maximize employment, the Fed runs the risk of failing on both fronts because you need stable prices in order to achieve a strong economy and maximize employment.

Lastly, I just want to acknowledge the unique and crucial role played by the Fed in our economy, and some of the responsibilities that attend to that. The ability to direct interest rates and control the money supply is of course an extraordinary power, and Congress has given the Fed a great deal of operational independence in order to isolate it from political interference. But Congress also gave the Fed a narrowly defined mission. I am troubled by the Fed… misusing this independence to wade into politically charged areas like global warming and racial justice. I'd suggest that instead of opining on issues that are clearly beyond the Fed's mission and expertise, it should focus on an issue that clearly is its mandate, controlling inflation. If it doesn't, the Fed will find that its credibility and independence may also have turned out to be transitory…

Let me turn to housing prices a bit. The Case-Shiller Home Price Index showed housing prices across the U.S. as a whole increased in May by more than 15% from the previous year… Fifteen percent, clearly, is making housing less affordable, more out of reach for more people. So, a number of voices within the Fed seem to be increasingly concerned about this. The St. Louis Fed president, James Bullard, said just this week that he is… ‘a little bit concerned that we’re feeding into an incipient housing bubble…’ Dallas Fed President Robert Kaplan said that the Fed should begin tapering to begin offsetting ‘some of these excesses and imbalances’… The Boston Fed president, Eric Rosengren, raised alarms that the Fed's mortgage-backed security purchases may be contributing to the current boom in real estate prices, citing the potential financial stability implications… I’ve been clear for a long time I’ve been very skeptical about the ongoing mortgage-backed purchases. Are you at all concerned about the unintended consequences that are associated with $40 billion worth of mortgage-backed security purchases that continue month after month?”

Chair Powell: “So, housing prices are going up, as you mentioned, around 15%. This is a very high rate of increase. A number of factors are contributing. Monetary policy is certainly one of those factors. There are also other factors. People have very strong balance sheets that they’re able to make down payments. There are also supply factors that are constraining the supply, at least temporarily.”

South Dakota Senator Mike Round: “I understand that clearly you’ve made it your mission to adhere to the guidance for the Fed, in which you work to maintaining 2% inflation over a period of time, as well as full employment. And when we talk about it, it’s always a combination of which one you’re more focused on and how you maintain that, while at the same time responding appropriately in a nonpolitical way to the actions of Congress and the administration.

I'm just curious, with regard to today’s position, we’re coming out of a pandemic. We’ve put a lot of fuel into the economy with direct payments and so forth, and people are trying to get back to work right now. And yet we’ve got inflation, which right now in this current state seems to be above a 2% rate. Can you talk a little bit about the measurement time period that you believe is appropriate for shooting for a 2% goal, and if there is a concern that you would express or that you follow-up with when we talk about overinflating or perhaps putting fuel in. What concerns you would have and how you would respond to congressional activity?”

Powell: “So, the inflation that we have today, what we’ve said is that if inflation runs below 2% for an extended period, we want inflation to run moderately above 2% for some time. This is not moderately above 2%, by any stretch. This is well above 2%, and we understand that. And it’s also not tied to the things that inflation is usually tied to, which is a tight labor market, a tight economy, that kind of thing. This is a shock going through the system associated with reopening of the economy, and it’s driven inflation well above 2%, and, of course, we’re not comfortable with that. In terms of the test that we articulate, we said we wanted inflation to average 2% over time. We didn’t tie ourselves to a formula. What we really want is inflation expectations to be anchored at 2%, because if they’re not, there’s not much reason to think that inflation will average 2%. So that’s really how we're thinking about it.

But the challenge we’re confronting is how to react to this inflation which is larger than we had expected, or that anybody had expected. And to the extent it is temporary, then it wouldn’t be appropriate to react to it. But to the extent it gets longer and longer, we’ll have to continue to reevaluate the risks that it would affect inflation expectations and will be of a longer duration. And that’s what we’re monitoring.”

Tennessee Senator Bill Hagerty: “Chairman Powell, this environment suggests to me that the emergency posture that I understand the Fed adopted back during the depths of the pandemic seriously needs to be reconsidered right now, and I’m very worried that the Fed’s continued level of asset purchases and balance sheet expansion is facilitating this runaway spending that the Democrats are imposing upon us, and adding to the inflationary pressures that these trillions of additional dollars are going to continue to add to our economy and continue to add to the debt that our children are going to continue to bear, and it’s amazing to me that not one Democrat in Congress is willing to speak out about this. So, Chairman Powell, why is the Fed maintaining its emergency monetary policy posture right now? And why do I understand that it may continue well into 2023?”

Powell: “We’re watching the evolution of the economy. We are noting that there’s still an elevated level of unemployment. We note that inflation is well above target, and we’ve discussed that. And we’ve said that we would begin to reduce our asset purchases when we feel that the economy has achieved substantial further progress measured from last December, so we’re in active consideration of that now. We had a full meeting last month to discuss that. We’ve got another meeting coming up in two weeks. So, we’ll be making that assessment, and as we assess the progress of the economy toward that goal, we will begin to reduce our asset purchases. We’ve set a separate test for raising interest rates, which is a higher test. And so that’s how we’re thinking about this today.”

North Carolina Senator Thom Tillis: “I’ve got to beat the inflation drum for just a minute here. The FOMC members insist inflation is transitory but it hasn’t inspired a lot of confidence in me. There were a couple of statements by President Mary Daly: In February, she declared ‘the pressures on inflation now are downward.’ In May, when inflation readings were at 3.9%, she said ‘the higher inflation readings would mean 2.4% to 2.6%.’ In June, she was predicting that inflation ‘could go above 3%.’ And despite months of relatively lowball projections, in response to Tuesday's high inflation readings, she confidently declared ‘we expect a pop in inflation like this.’ So I hope, from our perspective, you could see that we’re skeptical about some of the inflation projections. And I’ve spoken with a number of people in financial services industry, and when I ask them the question about transitory, I’m getting more of a response of ‘transitoryish’. So, can you give me a reason why you believe the Fed’s position on it being transitory, that it will snap back, why that’s still well-founded?”

Powell: “So let me start by saying that no one has any experience of what it is to reopen the economy after what we went through. And, so all of us are going to have to be guided by data and our views are going to have to be...”

Tillis: “Let me interrupt you for a second. I’d also like for you to answer that question in the context of the flow of money that’s been passed in the prior COVID relief packages. And we heard an announcement this week from the Speaker of the House and Senator Schumer that they have an agreement on another $3.5 trillion. I’m a part of a working group for infrastructure that could add about another $600 billion. So, answer the question in the context of how that future… How does that all fit into the credibility of future inflation projections?”

Powell: “So when we look at inflation, we look in the basket of things and we say ‘which of the hundred-plus things in the CPI basket are causing the inflation -- high inflation reading?’ And it comes down to really a handful of things, all of which are tied to the reopening – it’s used, rented and new cars, it’s airplane tickets, it’s hotel rooms and it’s a handful of other things, and they account for essentially all of the overshoot. And we think that those things are clearly temporary. We don’t know when they’ll end but they’ll go away. We don’t know when they’ll go away. We also don’t know whether there are other things that will come forward and take their place. What we don’t see now is broad inflation pressure showing up in a lot of categories. The concern would be if we did start to see that. We don’t see that now. We’ll be watching carefully, and we won’t have to wait a tremendously long time to know whether our basic understanding of this is right. We will know because we'll see if inflation is spreading more broadly, that’ll give us information...”

Alabama Senator Richard Shelby: “Chairman Powell, we’ve been talking about inflation, and it’s not going to go away, I think, for a while. So, we’re going to continue to talk about it, and you'll be concerned with it. In June, U.S. inflation accelerated at its fastest pace in 13 years. Consumer prices increased by 5.4% from a year ago. Americans are now paying higher prices for many of the goods and services that they cannot do without… Yet, in the midst of the increase in consumer prices…, the Biden administration is proposing trillions more in government spending. The Fed’s ability to maintain price stability is threatened, I believe by actual inflation or the expectation of inflation… When taking all this into consideration, which you have data that we probably don’t have, do you believe that our nation is facing a real problem with inflation? And if not, why not? How do you justify it?”

Powell: “I think we’re experiencing a big uptick in inflation; bigger than many expected; bigger than certainly I expected. And we’re trying to understand whether it’s something that will pass through fairly quickly. Or whether, in fact, we need to act one way or the other. We’re not going to be going into a period of high inflation for a long period of time, because of course, we have tools to address that. But we don’t want to use them in a way that is unnecessary or that interrupts the rebound of the economy. We want to put people back to work. And there are a lot of people who are not back to work yet. But let me say we’re very well aware of the risks from inflation and watching very carefully. And if we come to the view that or if we see inflation expectations or the path of inflation moving up in a way that’s troubling, then we will react appropriately.”

Shelby: “Are you concerned about all the things that I just related? All the price increases unprecedented in recent years. Or are you just putting that aside?

Powell: “No, I mean, we’re, of course, night and day, we’re all thinking about that... and really asking ourselves whether we have the right frame of reference, the right framework for understanding this.”

For the Week:

The S&P500 declined 1.0% (up 15.2% y-t-d) (SPY), and the Dow slipped 0.5% (up 13.3%) (DIA). The Utilities jumped 2.7% (up 5.4%). The Banks fell 2.4% (up 24.0%), and the Broker/Dealers lost 2.0% (up 20.3%). The Transports dropped 2.4% (up 15.9%). The S&P 400 Midcaps fell 3.3% (up 13.5%), and the small cap Russell 2000 sank 5.1% (up 9.5%) (IWM). The Nasdaq100 declined 1.0% (up 13.9%) (NDX). The Semiconductors sank 4.1% (up 12.5%). The Biotechs dropped 4.3% (down 1.4%). While bullion increased $4, the HUI gold index declined 1.4% (down 11.5%) (GLD).

Three-month Treasury bill rates ended the week at 0.0425%. Two-year government yields added a basis point to 0.22% (up 10bps y-t-d). Five-year T-note yields slipped a basis point to 0.78% (up 41bps). Ten-year Treasury yields dropped seven bps to 1.29% (up 38bps) (SPTL). Long bond yields fell seven bps to 1.92% (up 27bps). Benchmark Fannie Mae MBS yields declined two bps to 1.75% (up 41bps).

Greek 10-year yields fell eight bps to 0.67% (up 23bps y-t-d). Ten-year Portuguese yields declined seven bps to 0.26% (up 23bps). Italian 10-year yields fell six bps to 0.71% (up 16bps). Spain's 10-year yields declined seven bps to 0.29% (up 24bps). German bund yields dropped six bps to negative 0.35% (up 22bps). French yields fell seven bps to negative 0.02% (up 32bps). The French to German 10-year bond spread narrowed one to 33 bps. U.K. 10-year gilt yields dipped three bps to 0.63% (up 43bps). U.K.'s FTSE equities index declined 1.6% (up 8.5% y-t-d).

Japan's Nikkei Equities Index recovered 0.2% (up 2.0% y-t-d). Japanese 10-year "JGB" yields declined one basis point to 0.025% (unchanged y-t-d). France's CAC40 declined 1.1% (up 16.4%). The German DAX equities index fell 0.9% (up 13.3%). Spain's IBEX 35 equities index dropped 3.1% (up 5.4%). Italy's FTSE MIB index declined 1.0% (up 11.5%). EM equities were mixed. Brazil's Bovespa index gained 0.4% (up 5.8%), and Mexico's Bolsa increased 0.8% (up 13.8%). South Korea's Kospi index rallied 1.8% (up 14.0%). India's Sensex equities index rose 1.4% (up 11.3%). China's Shanghai Exchange added 0.4% (up 1.9%). Turkey's Borsa Istanbul National 100 index fell 1.1% (down 7.7%). Russia's MICEX equities index slumped 2.2% (up 14.6%).

Investment-grade bond funds saw inflows of $4.408 billion, while junk bond funds posted outflows of $1.396 billion (from Lipper).

Federal Reserve Credit last week expanded $31.9bn to $8.080 TN. Over the past 96 weeks, Fed Credit expanded $4.353 TN, or 117%. Fed Credit inflated $5.269 Trillion, or 187%, over the past 453 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt last week rose $10.0bn to $3.538 TN. "Custody holdings" were up $133bn, or 3.9%, y-o-y.

Total money market fund assets dropped $31.0bn to $4.480 TN. Total money funds declined $89bn y-o-y, or 1.9%.

Total Commercial Paper dipped $4.4bn to $1.130 TN. CP was up $104bn, or 10.1%, year-over-year.

Freddie Mac 30-year fixed mortgage rates slipped two bps to a five-month low 2.88% (down 10bps y-o-y). Fifteen-year rates increased two bps to 2.22% (down 26bps). Five-year hybrid ARM rates fell five bps to 2.47% (down 59bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-year fixed rates down three bps to 3.04% (down 15bps).

Disclosure: Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion ...

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