Inflation is now the most significant factor in investment decisions. Until the Federal Reserve creates the conditions approximating price stability—defined as the core personal consumption expenditures deflator averaging 2% over a defined period—the economy will remain at risk.
We expect that the 10-year yield will move toward 3.45% by the end of the year, and it could go higher.
This will almost certainly send interest rates higher along the maturity spectrum. The question is how high? We expect that the 10-year yield will move toward 3.45% by the end of the year with upside risk and conditions that will result in an inverted yield curve—the spread between the two-year and 10-year rates—on a sustained basis. That yield curve inverted in April, and this past weekend it inverted again.
Price stability is a pre-condition for maximum sustainable employment, growth at or above the 1.8% long-term trend and financial conditions that do not risk upending the economy.
Until those conditions are in place, the Fed’s recent policies will result in tighter financial conditions and growth below the long-term trend. We believe those conditions will characterize the economy next year, and that there is a 35% of a recession over the next 12 months.
After range trading for more than a week, the S&P 500 promptly lost 3.5% in the two days leading up to the release of the consumer price index last Friday as it became obvious that oil prices would be behind the 8.6% headline inflation rate. Equity markets continued their decline after the inflation data was released.
In the bond market, 10-year yields had already doubled since the start of the year, rising from 1.5% to nearly 3% in the first week of June. That was punctuated by a 10-basis-point spike on Friday.
And with U.S. interest rates likely to move higher relative to trading partners in the G7—similarly experiencing high rates of inflation—the dollar gained roughly 2.4% on the euro after range trading for 12 days.
Inflation is not the only factor
As with every other commodity, prices of financial assets are determined by the supply and demand for equity shares and fixed-income securities.
To the extent that share prices reflect the profitability of corporations, investors in the stock market had recently been experiencing losses as the demand for technology and other items that were so popular earlier in the pandemic fell to earth.
Moreover, given the broadening out of inflation, investors are now anticipating lower corporate profits as inflation reduces disposable income.
In the fixed-income markets, the demand for short-term securities has continued to increase in the runup to anticipated Fed rate hikes. That demand is sending short-term rates lower even as investors seek protection from Fed rate hikes and higher costs for long-term securities amid increasing margin compression.
The result has been a steepening yield curve from money-market rates out to two-year bonds, with two-year bonds yielding 3% anticipating the trajectory of the federal funds rate.
The flatness of the yield curve from five years’ maturity out to 30 years implies a different scenario of subdued growth and reduced demand in the medium to longer-term. It suggests that growth will ease toward sustainable rates, with the implication of moderate levels of inflation.
The return on investment
The economy can no longer support the higher returns on investment earned in earlier decades, when the economy was growing by 6% per year in real, or inflation-adjusted, terms.
Going into the pandemic, that pace had slowed. Real gross domestic product was growing at less than 2% per year with a threat of deflation.
Given the profound demographic changes in the economy as the population ages and little to no chance of meaningful immigration reform, the probability of a sustained increase in growth much higher than the long-term rate is quite low.
The takeaway
Economic activity in the post-pandemic era will no longer rely on government income support and would be unlikely to support high rates of return on investment.
The implication would be for 10-year interest rates to rise above the 3% yields in effect just before the 2019 manufacturing recession, but not much more without an overhaul of the deteriorating U.S. infrastructure.
Given that there was only $16 billion in federal outlays to support infrastructure this year, investors, firm managers and policymakers should not anticipate any relief that would support faster growth or improved returns on investment this year.
