It’s Like Déjà Vu All Over Again … Again

by Eddy Vataru, John Sheehan, Daniel Oh of Osterweis Capital Management, 10/20/22

The Fed remains singularly focused on containing inflation but has made little headway so far. We anticipate the tightening cycle will continue, which will keep downward pressure on risk assets.

It’s Like Déjà Vu All Over Again … Again

Indeed, the more things change, the more they stay the same. As we wrote last quarter, the Fed continues to be singularly focused on containing inflation but has made little headway so far, despite two 75 basis point hikes in the fed funds rate. We suspected it might take time for tightening monetary policy to filter its way through the economy, and in this regard we have not been disappointed. Financial markets, on the other hand, have reacted much faster and continue to reprice risk, with higher yields and mostly wider corporate and mortgage spreads.

There are subtle signs that the Fed’s restrictive policy is beginning to have the desired effect on a few forward-looking inflation indicators, and it is also impacting interest rate-sensitive sectors, such as housing. While core CPI remains near its local high (6.3%), core PCE has dipped from its February peak of 5.4% to 4.9%. Our preferred index is the full data set measure of the Underlying Inflation Gauge (UIG), which mirrors core PCE’s drop – it fell from 4.9% in March to the latest reading of 4.5% (for August).

One reason we favor UIG – besides its advertised goal of identifying the persistent component of inflation – is that it eliminates a lot of the monthly measurement noise and volatility that can plague the other indices. UIG shows a definitive peak and several months of falling inflation, which is a promising development in this fight to curb rising prices. Still, 4.5% remains well above target and much more work is left to be done.

Turning back to the Fed, we see little change in the trajectory of its current tightening policy. The most recent “dot-plot” of forward rate expectations of Fed members has recast higher to more realistic levels. The relative resilience of the economy pushes our expectation for that elusive terminal rate hike higher – and further into the future.

Confounding the Fed response to this inflation event is its stubborn adherence to a 2% inflation target. We believe the current neutral rate of inflation is higher than 2% - we estimate it to be between 3-4% at present. If the Fed employs a restrictive policy that sticks with a 2% target, it is clear to see the potential for policy error.

Looking at rates, we continue to expect short rates to rise. Liquidity has been challenging in fixed income markets and we can no longer ascribe this to a seasonal summertime lull – large moves have become the norm in recent weeks and should continue, especially as global bond markets struggle to find their footing. Inflation has proven to be a global phenomenon, although Europe (as an energy importer) has fared significantly worse due to skyrocketing energy prices and the geopolitical uncertainty therein.

This leaves us cautious in U.S. fixed income markets. Risk rallies are severe but short-lived. Spreads are wide but can continue to stay wide or even widen further – especially in corporate bonds. The yield curve is inverted (2- and 3-year yields mark the peak at the time of this writing) and should continue to be relatively flat/inverted so long as the Fed raises rates. We expect the specter of recession will ultimately provide a bid to Treasuries, but we aren’t there yet. At present, we prefer yields realized in cash and high-quality commercial paper, until we see definitive signs of a pivot in Fed policy or the economy.

We would like to thank you again for your confidence in the team and welcome any questions or comments you may have.

It’s Like Déjà Vu All Over Again … Again

Sponsored Links

Trending Topics View All