INFLATION: HOW HIGH CAN IT GO?
By: Tony Minopoli
The question has become, how high can it go? By “it”, I am referring to the yield on the 10-year Treasury. Despite elevated inflation for about two years, the economy continues to grind higher. Employment remains strong and certain skill sets are in amazing demand. In the corporate world, try finding an accountant or an actuary. When I was in college, accounting was the most popular major in the business school. Finance, by comparison, was a much smaller major and it seemed like I knew everyone in my major fairly well. In any event, outside of the white-collar world, skilled labor is also an extremely tight part of the labor market. My son, a truly bright guy, figured out during his freshman year that college wasn’t for him. Instead, he transitioned to trade school while starting as an apprentice for a commercial electrical contractor in Connecticut. He is coming up on his third anniversary as a licensed electrician and early returns are showing great promise of success. Anecdotes notwithstanding, the labor market remains strong.
So, we have a strong labor market, with some cracks, but strong, nonetheless. We also have a continuing series of economic indicators illustrating that inflation hasn’t cracked yet. I have quipped in many presentations that in my over thirty years in the investment business, I have learned one immutable fact: I am smart enough to know that I am not smart enough to time the market. Then, I couple that with a great old market saying, “The market can remain irrational for longer than you can remain solvent”. So, what does this all mean?
The Federal Reserve has a dual mandate to maintain full employment and to maintain inflation. Employment, check. Inflation, not so fast! The Fed has been behind the curve since they lobbed the argument that the current bout of inflation should be viewed as transitory. We argued against this because inflation was being driven by the broken supply chain that was seeking to become less global, a strong employment market, continuing wage growth, and a return of energy inflation. The energy inflation is being driven, in part, by government mandates for renewables that are ahead of the technology in the renewable market. As the 10-year flirts with 5%, and it may get above that level by the time the compliance department reviews this essay, we continue to believe that we may be nearing the peak on the 10-year yield and the current inflation trend of declining inflation that started in July of 2022 will continue to grind lower[1].
The reason that we believe we may see rates rollover is because consumer delinquencies on credit cards are starting to increase and banks are tightening lending standards. Free-flowing credit is the lubricant needed to keep the economic engine humming and a confident consumer is needed to continue spending to drive economic growth. Also, it has typically taken about 18 months for Fed policy to truly impact the economy. As the impact of the Fed hiking cycle starts to be more meaningfully felt, we do believe we will see economic activity and inflation slow, and if investors become concerned with equities, a 10-year Treasury yield that starts with a “four” may be very attractive. We also believe we are not returning to longer bonds with yields below 2% because our debt and deficits have risen to levels where even the good old USA is going to need to pay up to attract financing. More to come on this, but just some current thoughts to consider.