Strategy
Unlike the first quarter when we saw interest rates rise in anticipation of stronger growth, the realization of a stronger economy has resulted in rates falling. The 10-year Treasury yield fell by 27 basis points and long bond yields have declined by 30 basis points. Despite commodity prices moving higher, homes selling for more than list, a waiting list to buy most major appliances, and labor costs rising, the Fed has assured us they will keep short-term rates near zero through 2022. This is where the story gets dangerous. A miscalculation by the Fed with respect to inflation can have significant ramifications. While Chairman Powell has indicated inflation will be transitory, what happens if he is wrong? Longer term interest rates will rise sharply, and the stock market should see significant declines. The Fed’s credibility will be negatively impacted for years. Economic activity will stall, and the lower income wage earners (the group he is trying to help) will be hurt the most.
...the Fed may need to slam on the brakes, rather than simply ease off the gas pedal.
Last quarter we examined the yield curve in order to see where the best value resided. The difference in yield between a 3-year maturity treasury and a 5-year maturity treasury was 55 basis points. The difference today is slightly narrower at 44 basis points. The yield gain from going from a maturity in 2 years to a maturity in 4 years is 43 basis points. The yield on the 2-year T-note is 9 basis points higher than on March 31st, while the 5-year T-Note is 6 basis points lower, and the 10-year Treasury is 30 basis points lower. It is obvious from this change that the market has the same view of inflation that the Fed has. If they are both wrong, the Fed may need to slam on the brakes, rather than simply ease off the gas pedal.
From our perspective it appears there will be more pressure on rates to rise, rather than to fall in the near term. In a rising interest rates environment, the most often non-regrettable place to invest is cash. This observation is based on having lived through numerous rising interest rate cycles. If cash is not a viable option or it’s an option for a portion of your assets, what else makes sense to buy? We have some ideas to explore.
On the shorter end, a 10-year agency MBS with a 2.0% coupon is currently priced in the mid 103’s, with a base case average life of 3.2 years and a yield of 0.80%. The PSA prepayment assumption is 380. If interest rates rise, and the prepayment speed declines to 300 PSA, the yield increases to 0.91% and the average life extends 0.3 years. The advantage to buying premium priced MBS in a rising interest rate environment is the yield increases as the average life extends due to fewer homeowners refinancing. The higher the premium the more the yield increases. Most investors are comfortable paying a price in the 102’s but few are willing to pay in the 104’s. Looking at a seasoned 15-year MBS with a 2.5% coupon priced in the mid 104’s the base case average life is 3.1 years and the yield is 0.90%. The PSA assumption is 266. If rates rise and the prepayment speed falls to 188 PSA the yield increases to 1.10% while the average life extends 0.5 years. Seems like an attractive trade-off for a portion of your investible assets. In the MBS sector we would advise keeping the largest portion in lower premium product and a small portion in MBS with prices in the mid 104’s.
We recently purchased a Freddie K (agency CMBS) with a 3.7-year average life, bullet-like cash flows and the yield spread was 30 basis points more than a like-maturity Treasury. The yield was 1.06%. The security was priced slightly over 109 but the structure of the particular Freddie K provides for prepayment protection not offered on passthroughs. At a very fast prepayment speed, the average life only falls by 0.25 years and the yield declines 10 basis points. These securities had traded much tighter on a yield spread basis and now offer much better value in our opinion.
Interest Rate Outlook
In order of sequence, we think that the second half of the year will offer an evolving degree of false certainty including politics, a developing inflation story, the employment environment, and Fed policy. In July through September, the physical and social infrastructure investment plans will be the hot topics. In late June, President Biden announced a bipartisan agreement on the physical infrastructure deal for a mere $579 billion, a significant reduction from the nearly $2 trillion sought. As several senators looked on, proud of their achievement in finding common ground, President Biden announced the bipartisan deal would only be signed if it were accompanied with the $2 trillion social infrastructure spending. Apparently, there wasn’t a meeting of the minds. The battle that now ensues is not Republicans versus Democrats, rather it seems the final deals will be hashed out between the progressive and moderate Democrats. Our expectation is that the progressives will determine it is better to get a combined package of $3 trillion, than it would be to walk away empty-handed. The current Senate “deal” being discussed involves $3.5 Trillion in social spending and the $579 billion bipartisan deal that addressed traditional infrastructure, but key moderate senators were not a part of the negotiation so the final deal will likely be smaller. Mid-term elections are just around the corner and another hit of spending will be helpful to their re-election efforts. Two “wild cards” to watch out for include a “scorched earth” event where progressives decide the infrastructure investments must exceed $4 trillion (to meet green energy, healthcare, affordable housing, home care, citizenship and tax fairness goals) or they will accept no deal. That outcome would indicate a disturbing reinforcement of the idea that “those who don’t think as you do are obstacles.” Compromise has become old-fashioned. The other possible unexpected outcome is an extension of the enhanced unemployment benefits to give working families the chance to get the “right job,” rather than just any job. Such a program could easily be intertwined with any number of moves toward a universal basic income effort. We think both events would cause major market disruptions. Mechanically, look for Democrats to pass the legislation in the Senate using budget reconciliation to get around the filibuster. Congress will vote on an outline of the tax and spending program in July, but they likely will not take up the final legislation until September.
There are areas where dramatic signs of inflation exist, but in many cases, they will prove to be transitory.
Inflation concern is an area we can get behind as a topic for reasonable discussion and disagreement. There are areas where dramatic signs of inflation exist, but in many cases, they will prove to be transitory. A couple of other areas have yet to be determined, or they have exhibited signs of inflation in segments of the economy that we believe is less prone (or postured for) price corrections.
The Fed’s expectation that broadly inflation will be transitory has driven the continuation of their accommodative stance. Real GDP growth expectations for 2021 are 6.6%, with the second quarter annualizing at what is expected to be an annualized peak of 10%. It would be the strongest year for growth since 1983. The same base effects that are making the growth and inflation numbers look so strong this year will likely make the growth and inflation numbers look underwhelming in 2022 (and that too may feed into political strategy). Mark Zandi, chief economist at Moody’s, estimated that without more spending programs, growth could slip to 1.5% to 2% in the second half of 2022. Others have speculated that the passage of more spending could add between 0.5% and 1.5% to GDP.
To this point, most of the signs of inflation have been in the area of “goods” rather than services. Whereas “goods” have seen growth accelerate 5.3% over the past year, the strongest number since 1991, the (more important) “core services” inflation number is up a surprisingly modest 0.30%. Much of the recent rise in the CPI data is explained by reopening areas, such as airfare, used vehicles, vehicle rentals and sporting admissions, all up 10% from March to April. Commodities made headlines earlier in the year. Lumber in particular saw futures prices hit roughly $1,700 and have since plummeted to just over $700. The issue with lumber was not a lack of timber, but a bottleneck at the mills and transportation challenges. It is a good example of how supply shortages can lead to dramatic signs of inflation that are subsequently addressed. Many of these “out of control” signs of inflation will turn out to be transitory.
Perhaps less transitory is the impact that lumber prices had on new home construction, which may have trickled thought to the existing home and rental markets. The soaring lumber costs added roughly $35,000 to the cost of a new single-family home and accounts for 17% of the average home’s construction cost. Low-cost financing is also contributing to buyer’s ability to tolerate increasing purchase prices. According to the website Apartment List, the median rent has increased 9.2% for the first six months of 2021. In addition to commodity cost increases, it is believed that Millennials are beginning to form households at a greater pace and due to work location flexibility and livability preferences, there may be in increase in demand for non-urban living. The March 2021 release of the Case-Shiller Housing Price Index showed that existing home prices increased more than 13% as compared to a year earlier. Combine the increased housing costs with elevated fuel costs, which based on supply and demand dynamics should see price support for some time, and the average person may feel the nagging effects of non-transitory inflation chiseling away at their disposable income. The substitution for high rents isn’t a quick or easy transition, it involves saving money for a down payment on a house or changing legislation to reduce the requirements to benefit from U.S. government agency-backed mortgage financing. Expect housing costs to be a pain point for the foreseeable future.
Labor markets hold the key to the more meaningful long-term inflation outlook and the Fed’s resulting policy reaction.
The 800-pound gorilla in the room is the most important cost that will drive all other forms of inflation: labor costs. There may be some legitimacy to the claim that childcare is hampering the employment pursuits of some job seekers, but the enhanced unemployment benefits, where roughly 2/3 of the recipients are better off collecting benefits and not working, explains why we have 7 million more job seekers looking for work opportunities than was the case before the pandemic. Less mentioned is the fact that businesses report that they have 9.2 million available positions, 2 million more than in February of 2020. Also of interest, private sector job “quit” rates are the highest they have been in more than 20 years. Perhaps high-quality workers, or those with special skill sets, are using the current labor market to switch jobs and possibly increase wages. For low-skilled labor, their best hope may be that government efforts to sideline some lower-wage workers will artificially increase their future pay. According to Forbes website, a Minnesota resident who is receiving enhanced unemployment benefits, receives the equivalent of more than $17/hour. Many people say that wages are a sticky cost, but in low-wage and low-skill tasks, turnover tends to be high and over time, productivity enhancements can be implemented. As an example of how the market is addressing employee scarcity challenges, Southwest Airlines announced they are increasing their wages to $15/hour. Around the same time, FedEx announced that they were increasing capital spending by 20% over the next year to invest in 16 automated facilities. Labor markets hold the key to the more meaningful long-term inflation outlook and the Fed’s resulting policy reaction. Unfortunately for all the job seekers out there, an odd development that caused average hourly earnings to spike last year, possibly resulting from employers laying off their lowest-paid workers first, may cause wage growth headwinds. Once the pandemic-related labor market safety nets are removed, a glut of lower-skilled and lower-wage workers will hit the job market in September, possibly causing unemployment numbers to get worse and it could very well drag hourly earnings growth numbers lower.
Fed policy has been extremely accommodative throughout this pandemic episode. They must operate in a way that maintains credibility, while supporting their dual mandate (full employment and price stability), while not causing market dependence on monetary stimulus. Real yields, as measured by the 10-year Treasury yield minus the headline inflation rate have dipped as low as negative 3.7% in 2021. For context, over the past 70 years, real yields have only been lower for 10 months (during 1974 and 1980). Through their security buying programs and other credit spread manipulation efforts, as compared to the current level of inflation, it almost costs nothing to borrow money – even for “junk” rated borrowers. Some of the Fed efforts may have contributed to the most worrisome areas of inflation. Specifically, the Fed purchasing $40 billion a month of new mortgage-backed securities has kept mortgage financing costs near all-time lows. Cheap financing factors into overall home price “affordability” and as a result purchase prices have quickly moved higher. If inflation shows convincing signs of being transitory, the Fed will need to do a masterful job of coaching the market to believe that moving toward a self-sustaining economy is actually a good thing. We expect it will be a bumpy ride as economic signals confirm and refute whether inflation is well-behaved and in line with the Fed’s stated targets.
There are signs that the market has belief that the Fed may be pursuing the correct course of action. The yield curve has flattened which suggests that people expect that at a point, the Fed will remove some accommodation and raise short-term rates. It also indicates that the outlook for “run-away” inflation is muted. Through the Fed’s “Dot Plot” released after each meeting, the current expectation of the voting members of the FOMC anticipate two rate hikes in 2023. Perhaps even more interesting is the start of discussions regarding the eventual tapering of asset purchases, which is now anticipated to start at the end of 2021 or the first half of 2022. Perhaps we may be reading into things too much, but we find it worthy of watching that only two more FOMC members will have to vote to move their dots into 2022 to have a majority of FOMC members anticipating a rate hike in 2022. The Fed has many tools to fight inflation; it is disinflation that has plagued them for much of the past 13 years. We anticipate after a short visit with inflationary pressures during the next six months to a year, the Fed will have to continue the struggle with disinflation while trying to ween the market off its dependance on monetary stimulus.
In the near term we expect that “shock and awe” spending will cause interest rates to rise in the next six months.
In the near term we expect that “shock and awe” spending will cause interest rates to rise in the next six months. Once the government unsustainable spending smokescreen allows for clearer price signals and the realization of how the investments will be funded, we may resume demand softness next year. For context, President Biden is proposing a 25% expansion of government spending, from 20% of GDP before the pandemic to 25%. The “trickle up” economic model, where money is transferred from savers and investors to consumers, should weigh on future productivity growth, and by extension it may be an economic drag. Offsetting some of the future disinflationary pressures may be the adoption of green energy mandates. That is not to say we don’t like having environmentally friendly options and technology, but just about every new technology is expensive at first, and mandates will hurt lower income families disproportionately for a while. For them, it will be phantom inflation in that they will simply pay more for no functional benefit (but it will be up to the individual to decide if altruistic utility outweighs the diminished functional utility).
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