Market volatility continued in June as investors expressed relief that much of the Covid-mandated restrictions had been lifted while simultaneously worrying that the more serious Delta variation could possibly force the population back into quarantine. While the latter caused an occasional plunge in stock prices, the corrections have been short lived as long bond yields have steadily fallen, with the 30-year note below 2.00% at the time of this writing.
The march to 2.00% has not been a straight line though. The release of the FOMC Committee minutes on July 7th did unsettle the markets somewhat. The minutes are usually about as exciting as American cheese, but got the attention of investors this time around. The message from Chairman Powell following the last FOMC meeting was that the Fed had begun to discuss tapering their open market asset purchases but reiterated that they will be patient given their view that the recent uptick in inflation will be transitory. Reading through the minutes though, it seems several members are not fully in consensus with the Chairman’s message. Some are clearly more worried about inflation than others. Last fall the Fed adopted what they called Flexible Average Inflation Targeting (FAIT), a policy that gives them a “fudge” factor to work around higher than expected inflation. It seems some members have a difference of opinion on how flexible to be and, in turn, how soon to reverse their easy money policy.
Compounding the problem was the terrible inflation results for June, with both the consumer price index (CPI) and producer price index (PPI) exceeding both the prior month result and coming in well above expectation. Economists had been looking for the year-over-year CPI to register 4.9% but were surprised when the actual YOY price increase was 5.4%. To put that into perspective, with the 10-year note yielding 1.36%, the real return to a fixed income investor is -4.04%. As we have discussed on occasion, such a negative real return means that an investor in the 10-year would lose 4.04% buying power over the course of a one year holding period. Chairman Powell has assured the investing public that the recent bout of inflation is only transitory and that inflation will return to the Fed’s 2% target. Even at a 2% annual rate, that implies a real return of -0.64%.
Under normal circumstances, traders would short the bond market and drive interest rates higher until they got back to equilibrium. The long run equilibrium interest rate of the 10-year note is 200 basis points above the inflation rate. Ignoring the most recent CPI number and instead using the Fed’s 2.0% targeted inflation, that means that the fair value interest rate of the 10-year note is 4.0%. Such a move would result in approximately a 20% price drop which would be disastrous for current bond holders, not to mention that it would likely cause stock prices to crash and home sales to come to a screeching halt. For that reason, the Fed wants to be slow in tapering the purchase of Treasury and mortgage-backed paper. However, by not tapering, they’re postponing the inevitable return of Treasury interest rates to something resembling fair value. Such is the dilemma Chairman Powell finds himself. Exacerbating that dilemma is former Fed officials and well respected economist’s have been vocal in identifying the current policy as a mistake. Also of consideration, Powell is in the last year of his term as Fed Chairman. He’s proven to be malleable to the wishes of President Trump and seems likely to be the same for President Biden. It seems unlike that we’ll reach the end game this summer, but the fourth quarter could be another story.
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