Week of 10/25/2021

Powell on Rates, Taper & Inflation… Market Expectations… Money Managers Contradict Market Signals…Wall Street Leaders on Inflation… Drivers of Inflation… Lower Growth Prospects… Markets Expect Higher Taxes…

Powell on Rates, Taper & Inflation…. “I do think it is time to taper,” Fed Chair Powell said Friday. “I don’t think it is time to raise rates.” Mr. Powell and other Federal Reserve officials have signaled strongly that the Fed would formally announce a gradual reduction, or tapering, of its monthly purchases of $120 billion in Treasury and mortgage debt at its Nov. 2-3 meeting. The Fed has anticipated that price pressures could abate as the pandemic subsides Mr. Powell said it would be important for the central bank to stay flexible in the months ahead. The central bank will “need to make sure that our policy is positioned for a range of possible outcomes” but at the same time, “no one should doubt that we will use our tools to guide inflation back down to 2%” if more persistent inflationary pressures were taking root. Global supply chain constraints and shortages that have led to elevated inflation “are likely to last longer than previously expected, likely well into next year,” Powell added “it is still the most likely case” that as those constraints ease, “as they eventually will and as job gains move up inflation will move back down closer to our 2% goal.” Fed Chair Powell added “We think we can be patient and allow the labor market to heal.”

Market Expectations… Higher odds, a 75% probability, for at least two interest rate increases by the end of 2022 are reflected in futures market prices. Market implied expectations for inflation surged to the highest in over a decade.  Over the next ten years, traders anticipate inflation to be 2.64%.  Policy makers have room to overlook COVID-19 driven transient price pressures as the Federal Reserve’s new policy approach is based on long term average inflation targets. Federal Reserve Vice Chair Richard Clarida noted, “I continue to believe that the underlying rate of inflation in the U.S. economy is hovering close to our 2% longer-run objective and, thus, that the unwelcome surge in inflation this year, once these relative price adjustments are complete and bottlenecks have unclogged, will in the end prove to be largely transitory.”

Money Managers Contradict Market Signals… Contradicting market signals, large institutional investors feel that the markets have gone overboard pricing in interest rate hikes by the Federal Reserve. The inflation threat could prove temporary. “We believe the Fed’s rate hike path will be shallower than the current market pricing,” the chief fixed income strategist of the world’s biggest asset manager, PIMCO, stated. A BMO Capital Markets strategist, who expects the first rate hike in late 2022 or early 2023, noted “It’s not the type of inflation that the Fed has historically been willing to adjust monetary policy to counteract.” BlackRock strategists expect the Fed to stick to its plan to raise rates in 2023, as indicated in the so-called dot plot. Goldman Sachs’ chief economist thinks the Fed could announce tapering of asset purchases this year, but will not move directly to rate hikes in 2022 as U.S. growth is slower than earlier estimated. Investor attention is glued on the timing of rate hikes.

Wall Street Leaders on Inflation… The path of inflation “has become more uncertain lately and over that five-year time horizon it’s going to remain uncertain,” a PIMCO economist added that, “the market’s still giving Fed a lot of credibility around its longer term average inflation goals.” Inflation is the biggest source of concern for Goldman Sachs. “Most CEOs I talk to today are concerned about supply chain, very concerned about import costs, whether they’re materials, commodities and increasingly labor,” Goldman Sachs CEO stated at a recent conference. JP Morgan CEO noted that inflation probably will not drop across the next few quarters. “A large share of businesses in the region have responded to the disruptions by increasing their selling prices and scaling back their operations,” the New York Federal Reserve researchers say, and the IMF echoed that “Inflation risks are skewed to the upside.” Some top executives think that it could take a year or two for inflation challenges to ease. Meanwhile leaders at HSBC and Bank of America have downplayed inflation. Inflation faces both upside and downside risks.

Drivers of Inflation… “Core prices” that exclude volatile food and energy categories, the Fed’s preferred gauge, are up 3.6% in August from a year earlier. The price gains mostly reflect supply chain disruptions and shortages of labor and materials. This is most visible in the car market. Car prices surged this year as a global semiconductor shortage reduced production and depleted inventory. With soaring prices, car sales have plummeted 33% after peaking this year. Supply chain issues prevent manufacturers from ramping up production to ease higher prices. Rising energy prices, which are driven by global supply and demand, could prevent inflation from abating as quickly as anticipated. Higher energy prices will boost growth in the headline CPI and also bleed into core inflation via higher transportation costs and higher prices for public transportation and airfares, leading to broader price pressures.

Lower Growth Prospects… Higher consumer prices are beginning to weigh on consumer spending, reducing GDP growth. Fewer car sales and lower business investment will likely shave 1 to 1.5 percentage points off third-quarter GDP growth; while Hurricane Ida and Delta variant related lagged return to offices likely trim a few points off third quarter GDP growth, Moody’s calculated. Worries about the state of the economy alongside higher prices have led some to speculate about stagflation. Monthly job growth has fallen well short of expectation in each of the past two months. Real GDP growth in the third quarter is set to come in at only 2% annualized, and labor market challenges could be resolved by 2023, per Moody’s Analytics. Goldman downgraded economic growth prospects to 1.75% annualized in the fourth quarter and 4% in 2022.

Markets Expect Higher Taxes… Market pricing for top marginal tax rate is 48%. “Value of the tax exemption is going to grow” a BlackRock strategist said as lawmakers debate the final outcome of massive social spending paid by tax hikes on the wealthy. Treasury Secretary Janet Yellen has talked about a billionaire’s tax. Nuveen CEO echoed, “On a relative basis, particularly if your taxes are going higher, municipals are still a good overall story.” “We expect rates to remain relatively range-bound, enabling lower but positive returns for core bond allocations,” a PIMCO strategist noted. Likely higher taxes suggest high yield muni bonds could hold on to their gains. Credit improvement is a central theme for high yield muni bond investors. States and locals have earned accolades for boosting funding to schools and colleges, as well as underfunded pensions. Direct federal aid received by states and locals will be spent over multiple years, suggesting improved revenue prospects for many lower rated states and local governments. Institutional investors reckon that the rally in high yield debt may not continue at the same pace as the past year. Meanwhile, droves of institutional investors have boosted their stakes in Puerto Rico bonds. Since Feb 2020, Nuveen has tripled its holding of Puerto Rico bonds, while Mackay and Invesco nearly double their exposure to the Island’s triple tax-exempt bonds. The buying frenzy reflects demand for tax-free bonds.

Compare 30-Year taxable U.S. Treasury yield 2.11% to 30-Year tax-exempt muni bond yield “AAA” 1.80%; “AA” 2.08%; “A” 2.28%; “BBB” 2.50%. For investors in the 35% tax-bracket, a 2.4% tax-exempt yield is equivalent to a 3.7% taxable yield. Top rated tax-free bonds yield 85% of comparable taxable U.S. Treasuries.