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To Taper or Not to Taper?

To be or not to be? That is the question:
Whether ‘tis nobler in the mind to suffer
The slings and arrows of outrageous fortune,
Or to take arms against a sea of troubles,
And by opposing end them?

One can imagine Hamlet’s words running through Fed Chairman Jerome Powell’s mind last month as he gazed upon the snow-capped Tetons near Jackson Hole, Wyoming. His highly anticipated speech at Jackson Hole, expected to illuminate future Fed policy, instead reflected his uncertainty. Expectations that the Fed would announce a “tapering” of its hyper-aggressive monetary policy were dashed, and instead a sort of muddle-through plan was put forth. Like Hamlet, Powell seemed struck by indecisiveness, leading him to straddle the line between action and inaction.

Powell’s dilemma is no less profound than that of Shakespeare’s tragic hero. One the one hand inflation is reappearing at almost every level. Rising raw materials, shipping costs, food prices, and energy all contributed to the Consumer Price Index’s rise of 0.5% in July (up 5.4% in the last 12 months). Rents and home prices rose at double-digit rates in the year to July 31.

One cost the Fed has been able to safely ignore for the last twenty years is rising wages, which have been relatively stagnant at the lower end of the pay scale. Now, however, higher wages have started to show up. Regardless of what the unemployment numbers say, there’s a shortage of people ready to work at the going rate of pay, prompting many businesses to boost pay or offer bonuses in order to keep the doors open. Indeed, the Bureau of Labor Statistics reported that overall wages grew 0.6% in August, a 7.2% annualized rate.

On the other hand, recent economic reports have shown a distinct softness, prompting economists to ask whether the economy is now slowing.  Covid’s rise, along with the end of stimulus checks and eviction moratoriums may already be impacting growth.  For example, the most recent jobs report was a big disappointment, coming in at about one-third the consensus estimates of job creation for the month.  Only 235,000 jobs were created versus an expectation of 635,000.

Industrial production indices also show signs of slowing.  These measures have strongly risen this year, so it should not be surprising to see them pull back a bit, and they are far from signaling outright contraction in activity.  But a closer reading of the respondents’ comments sheds light onto what they are dealing with.  Consistent laments by businesses center around the unavailability of people willing to work, unavailability of raw materials due to supply chain constraints, and the uniformly rising costs of both inputs and labor.  Costs of production are now being passed onto the end customers simply because companies are afraid of operating at a loss otherwise, helping to feed inflation at the consumer level.  For now, demand for goods remains high, but meeting that demand remains a challenge.

Finally, consumer confidence took a large and unexpected drop in the last two months.  Since consumer spending drives over two-thirds of U.S. economic activity, this measure is scrutinized for clues as to America’s mood.  The consumer confidence indexes of both the Conference Board and the University of Michigan fell to levels below those of January 2020, just before the pandemic.  Joining these was the Small Business Optimism Index, which saw marked declines in optimism in late summer.

It is not hard to understand why confidence is feeling deflated these days.  The rise of the “delta” variant strain of covid has taken Americans by surprise with its transmissibility and virulence, providing a grim vision of déjà vu as hospitals are again overwhelmed by covid cases and the availability of intensive care beds runs dry.  This has no doubt impacted the keenness of people to socialize or travel, and we are starting to see declines in restaurant traffic and TSA passenger boarding data.

Rising costs of living, especially for rent and home purchases, have not been lost on the American consumer.  The need to adjust lifestyles due to rising costs had been cited frequently as a reason for the drop in consumer confidence, with the biggest impact being on intentions to buy a home.  High home prices have now turned into a deterrent for consumers as many starter and mid-range homebuyers feel priced out of the market.

An inflationary psychology may be starting to take hold among consumers and businesses.  This is a key element to understanding whether inflation persists, or is “transitory” as the Fed insists.  Human behavior is very difficult to change, and once a belief system takes hold it may be in place for years.  An important reason inflation had been persistently low over the past three decades is that everyone believed the Fed would keep it at a low level.

Is it any wonder the Fed’s Powell feels like he is suffering the slings and arrows of outrageous fortune?  Current policy, which includes printing $120 billion per month via “quantitative easing” (QE), is now fanning the flames of inflation, and argues for tapering the extraordinary stimulus of the last eighteen months.  But the resurgence of covid, the reluctance of workers to jump on the numerous job openings, and falling business and consumer sentiment worry the Fed that tapering now may occur at exactly the wrong time for the economy.

How is an investor to cope with these conflicting outcomes?  Stock investors seem to be cheering for disaster, as any bad news is interpreted as a likely continuation of the money-printing gravy train.  Traditional valuation analysis has been thrown out the window in this bull market, along with the belief that growth is impossible without perpetual monetary and fiscal stimulus.  Thus, all the bulls have going for them is hope for continued QE cash flowing into the stock market.

It is therefore the bond market to which investors should look for clues as to the future course of financial markets.  Interest rates represent the most basic building block upon which past and modern financial systems are based.  The Fed really only controls very short-maturity yields of the bond market, hovering of course near zero percent, though its QE efforts over the last decade have pushed long-term bond yields lower as well.

We believe that inflation will persist long enough in the quarters ahead to force the Fed’s hand to reduce stimulus and taper its high level of money printing.  The bond market appears to be waking up to the risk that inflation may be longer-lasting than policymakers are leading us to believe.  As a result, bond yields are starting to act as if higher inflation, and thus higher yields, are coming.  A glance at the long Treasury bond yield chart below supports this idea.  From pandemic lows, interest rates have risen to a slightly higher high, before falling this summer.  Short-term momentum measures, however, have turned up again, implying that yields are on the rise.  From a trend perspective, bond yields now seem to be tracing out a pattern of higher highs and higher lows.  This is a classic sign of a reversal pattern, where the value (price, yield, etc.) begins to shift from a “down staircase” pattern to an “up staircase” pattern.  The upward momentum of yields (bottom half) shows that yields may be completing a higher low which would strengthen the case that an uptrend is intact.

Inflationary readings are likely to remain high as the effects of rising rents and home prices are about to be fully measured in the CPI, as they get incorporated with a lag time of about four months.  Investors should expect inflation to surprise on the upside and dominate the headlines in coming months.

Indeed, numerous Fed board members expressed their opinions that tapering of QE should begin immediately, a rare show of dissent highlighting concerns about Main Street inflation and stock and real estate bubbles.  The chorus to taper monetary stimulus will likely only grow in the coming months, and we expect some sort of tapering will begin before the year is out.

We are operating under the assumption that inflation is going to take monetary policy out of the Fed’s control.  The Fed, believing it has found the magic elixir of consequence-free stimulus in the form of QE, is likely to find itself behind the inflation curve, if it isn’t there already.

Possible beneficiaries of an inflationary environment may be TIPS (Treasury Inflation Protected Securities), which are inflation adjusted Treasury bonds, commodities and/or energy companies, precious metals and their miners, and perhaps food producers.  While not specific recommendations, these provide areas to research further as potential inflation hedges.

We don’t envy Chairman Powell’s dilemma, but feel that now is the time for the Fed to take arms against a sea of inflationary troubles and begin to taper its extraordinary stimulus measures.