FAIT Accompli? Strategic Income Outlook Third Quarter
The second quarter was mostly uneventful, as the economy continued to reopen, interest rates ground steadily lower, equity indexes gradually reached new highs, and volatility was mild. However, things changed suddenly in mid-June, following the Federal Reserve’s Open Market Committee (FOMC) meeting, where they gave us more clarity on potentially tapering their bond buying program and when they might raise short-term rates. Despite lingering questions about the sustainability of the economic recovery, particularly whether businesses can find enough employees to run at full capacity and when supply bottlenecks might be cleared up, the economic underpinnings were strong during the quarter which was constructive for the markets.
The market’s reaction following the Fed meeting was a dramatic flattening of the yield curve, driven by a rally in long-term bonds, but also an increase in short-term rates, concomitant with a selloff in the equity markets. This implies that investors were worried about inflation near term and also fear a weakening economic outlook long term. Specifically, in the days following the meeting, the 2-year Treasury yield increased from 16 basis points to near 27 basis points, while the 30-year Treasury yield plummeted from 2.21% to 2.03% in two days before settling at 2.10%. While not seemingly large moves on the surface, this equated to a four point rally in the long Treasury followed by a three point correction, all in the course of seven trading days! While a bit unsettling, things appear to have calmed down for now.
There is still a meaningful difference of opinion regarding how long elevated inflation readings will last and whether the Fed is going to be right about the temporary nature of this bout of inflation or whether they will once again need to play catch-up if they are wrong. Regardless, the FOMC meeting provided insight into when the Fed may raise rates, as shown in the infamous Dot Plot, which we have discussed in the past as being very unreliable but still widely followed for lack of anything better. Currently, the Dots point to 2023 as when we may see rate normalization. The committee also admitted that inflation is currently strong, but still feels it will subside once pent-up demand normalizes and supply bottlenecks ease. They are sticking with their Flexible Average Inflation Targeting (FAIT) for now, but have not added any clarity to their tolerance for how much average inflation needs to rise above their 2% target nor for how long it would need to stay above 2% before they act. Nothing like keeping your cards close to the vest!
Inflation is a complicated and nuanced subject. The most recent bout of inflation was driven by a sharp increase in commodity prices, especially in lumber and metals, as well as for semiconductor chips. Clearly, supply chain disruptions are partly to blame as are manufacturers’ habit of keeping minimal inventory on hand. We saw this most clearly in semiconductor chips which went on to create shortages in a number of products, most notably automobiles, which drove the price of used cars higher. It wasn’t that supply was lacking, per se, but that the industry was unprepared for the large spike in demand. In April, for example, despite shipping an all-time record volume of semiconductors, global demand was still well in excess of supply. Increasing the supply of semiconductors is not as easy as flipping a switch but over time more fabs will be built and equilibrium should return.