In titling this quarter’s outlook, it was a close call between Yogi Berra’s famous déjà vu quote and that of French writer Jean-Baptiste Alphonse Karr, “plus ça change, plus c'est la même chose” – which translates to “the more things change, the more they stay the same.” Although the Fed remains singularly focused on controlling inflation, as evidenced by the recent 75 basis point increase in the fed funds rate, we have yet to observe a meaningful drop in inflation. Not surprisingly, fixed income markets remained under pressure, delivering another quarter of negative returns characterized by spread widening and interest rate volatility.
Despite the acceleration of the Fed’s response, price increases persisted throughout the economy last quarter, as indicated by most every inflation metric, whether CPI, PCE (the Fed’s favorite), UIG (our favorite), or any of the others found in the alphabet soup. We look at UIG as an indicator of persistent inflation – in that sense, it has more value than the others, which tend to include price shocks from temporary disruptions. Further, Fed policy should be calibrated to bring UIG lower, and in our minds when we consider the Fed’s target of 2%, it is the persistent level of inflation that matters most.
Regardless of measure, we are nowhere near realizing this ideal. Markets recently have relished weakness in manufacturing and housing, interpreting both as signs that the economy is slowing, which should decrease inflationary pressures and allow the Fed to slow its pace. However, these headlines also suggest a recession looms, which helps Treasuries but hurts risk assets across the credit spectrum. And, just as quickly as you have a poor data point, a Fed speaker or pundit will reiterate the Fed’s commitment to squashing inflation – even in the face of economic weakness – taking the steam out of any Treasury rally.
This leaves the Fed and markets in a precarious position. Jerome Powell will not be taking victory laps around the Federal Reserve if he engineers a recession, particularly after a binge diet of quantitative easing, flexible average inflation targeting (a real gem), and the fed funds rate set at zero for way too long. The aggressive rate hikes are not a reflection of monetary austerity but simply a side effect of policy gone wrong – as the Fed has now created volatility after previously squashing it for too long and creating asset bubbles of all shapes, sizes, and flavors.
The unknown forward path of Fed policy brings back fond memories of studying quantum mechanics in college – specifically the Uncertainty Principle. In 1927, German physicist Werner Heisenberg asserted that one could not simultaneously precisely know the position and the momentum of a particle. In 2022, we assert the Fed cannot simultaneously know the forward path of the fed funds rate (per their dot plots) while the economic data that drive their estimates evolve and are uncertain.
Further, estimating a terminal fed funds rate should be taken with a grain of salt. The Fed again finds itself holding on to one handrail by its dot plot and the other by economic data. The Fed’s current tack of being solely focused on inflation is a step in the right direction, but it is too early to know how long or how far they will need to push short rates to achieve their inflation target.
We will continue to focus on all inflation measures, understanding the lags that exist between rising rates and their potential to stem rapid price increases. As we pointed out in our prior quarterly outlook, the notion of a 2% neutral inflation target is likely a figment of the past, and we believe the Fed should be happy with a 3% target in the intermediate term. However, the Fed has committed to a 2% long-term goal and abandoning it as the neutral target at this stage would eliminate what little credibility remains.
Our challenge is to try to estimate the true neutral rate of inflation and position accordingly. For now, this likely means higher short-term rates and wider spreads for risk assets, but ultimately it will depend on the trajectory of the economy. The best place to invest on a true sign of a slowdown is not the front end of the curve, but rather longer maturity Treasuries. This tends to be the playbook for fixed income investing in periods of rapid tightening, but we still think it best to wait for more evidence that the economy is slowing. Just think, what if this economy is stronger and more resilient than the market and Fed believe? We think it just might be, which suggests higher rates ahead. The yield curve may still invert, but if it does, we think it will happen at interest rates that are higher than levels observed at the end of June.
We would like to thank you again for your confidence in the team and welcome any questions or comments you may have.
© Osterweis Capital Management
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