Stocks rebounded from Monday’s sharp loss as investors reevaluated the economic impact of a sharp increase in the Delta variant of Covid-19. While the future courses of infection, hospitalization and deaths are uncertain, given the number of Americans who have already had the disease or have been vaccinated, it appears likely that a highly contagious surge will be sharp but relatively brief. Whatever its course, the odds that our economy shuts down again is highly unlikely. Some travel and leisure activities may be curtailed briefly, but there shouldn’t be anything more than a short-term wobble in overall economic activity. There was some concern when 10-year Treasury yields fell close to 1%, but that was more an aftermath of Monday’s panic than a response to any fundamental data.
Today, I want to discuss two topics; the bond market and inflation.
Let me start with bonds. I will divide bond investors into 4 classes.
1. The Federal Reserve. The Fed clearly has been a net buyer fairly persistently for much of the past decade. Its current rate of purchases is at the highest sustained rate ever. More buyers equals lower prices which equals lower yields. The Fed by policy wants to keep yields low.
2. Business. Businesses are loaded with cash. Excess cash gets invested in Treasuries, mostly of short maturities. Since the pandemic began, M2, the widest gauge of money supply, is up over 25% and is $5 trillion higher than before the pandemic began. As corporate cash grows, so does demand for Treasuries. More buyers means lower yields.
3. Individual Investors. They buy bonds for income and to reduce portfolio volatility. With yields less than the rate of inflation, bonds are a relatively unattractive investment today. Monetary policy is designed today to push investors to take more risk. Thus, much of the excess money is flowing not only to bonds, but to riskier asset classes. These include stocks, real estate, art, and yes, Bitcoin. All have risen substantially in value during the pandemic. While low yields push investors away, low volatility pulls them in.
4. Traders and Speculators. These are largely professionals trying to guess the next move in bonds. They leverage their bets significantly. They don’t add volume but they add volatility.
Bond prices reflect supply and demand like all asset classes. The Fed is a huge net buyer, as are businesses flush with cash. Individuals are also flush with cash. Savings are up $3 trillion since the pandemic began. Some has gone into bonds. Today’s volume of savings is up about 65% since the start of 2019. On the other hand, monetary velocity, the speed that money flows through the banking system, is half of what it was in the 1990s. Simply said, there is a tremendous excess of money sloshing around looking for a home. A good chunk of that goes into the Treasury market, not because yields are attractive, but because it is safe and secure. More demand from more buyers keep yields low.
How might that change? The Fed wants to buy fewer bonds in the future. It has said so. We don’t yet know when the tapering of purchases will begin and we don’t know how fast it will withdraw, but it will be a smaller buyer next year than it is this year.
The current spike in profits is helping to build corporate cash. How that grows isn’t just dependent on profits, it is also impacted by corporate policies relative to stock repurchases and dividends. Capital spending is rising, absorbing some of that cash. What we do know is that the rate of profit growth most likely peaked in the second quarter. The rate at which corporate cash builds on balance sheets should start to slow down. It will still grow but at a slower pace.
Now that Covid-19 restrictions are ending, individuals are starting to spend more. They are using credit cards more, flying once again, going back to work, purchasing new outfits, and even buying new homes at the greatest pace since more than 15 years ago. Expect the saving rate to decline.
Finally, all these record profits, both at the corporate level and at the investor level, likely will mean more taxes to be paid. Receipts at both state and federal levels are running substantially ahead of expectations. That should continue well into next year. The last time the U.S. had a budget surplus was in the late 1990s during a stock market surge. Expect smaller than expected deficits into next year. That will reduce borrowing needs versus expectations.
The bottom line is that inflated savings, robust bond buying by both businesses and the Federal Reserve, and the Covid-19 spike in Federal disbursements has created an unusual and unsustainable rise in investable cash. As those levels either grow more slowly or even decline, demand for Treasuries should fall as well. How low bond prices go is something beyond my pay grade. But I will be shocked if a year from now yields are significantly lower than they are today. The Fed has strong incentive not to let them rise too far or too fast, but a return into the 10-year range of 1.5-3.0% is a reasonable expectation.
Now to inflation.
Inflation is caused by an imbalance of supply and demand. Either demand rises faster than supply, or supply falls faster than demand. The Great Recession left us with an enormous excess supply of virtually everything. That included everything from products, manufacturing capacity, houses, and labor. Add in the impact of monetary easing, and there was even an excess of money. History has shown that it takes about a decade for a rebuilding economy to absorb the excesses left from a financial collapse. The Great Recession was largely in 2008-2009. A decade later much of the excess had been absorbed. By early 2020, unemployment was below 4%. Inflation was inching back to the Fed’s 2% goal.
Then came the pandemic.
Everything shut down. For some, the shutdown was 4-6 weeks. For cruise lines, the reopening has barely begun. Roughly 10 million workers were laid off or furloughed. Offices went vacant as did much retail space. Hundreds of thousands of restaurants closed their doors permanently. While we experienced a very brief but very sharp recession, money kept flowing. The economic world took a hard body shot but came back to life fairly quickly. Today’s GDP is higher than pre-pandemic. Money supply is much higher. People had to dig into savings to survive but those savings have been fully rebuilt.
I noted earlier that inflation erupts when demand exceeds supply. The economy’s resurgence, amid very low inventories, took most of us by surprise. Demand for key commodities, from timber to oil to food, spiked. However, high prices quickly brought out more supply and lowered demand. Look at the housing market. Two months ago, open houses had long lines and it was routine for buyers to offer more than the asking price without conditions. The high prices brought more sellers to market. They also led marginal buyers to disappear. Balance is being restored. Key, however, is that balance is being restored at higher price points. That $250,000 house that was $350,000 a year later may settle back a bit and take a little longer to sell today, but it isn’t going to be a $250,000 house again for a long time, if ever. That gallon of gasoline now well over $3.00 may fall below $3.00 again once summer ends, but don’t expect $2.00 gasoline any time soon.
Other prices are still climbing. Wage rates are starting to rise at an accelerated pace. Workers need to pay for the more expensive homes and gasoline. Speaking of homes, landlords are raising rents once again. Sharply higher home prices are increasing demand for apartments. Depending on your method of measuring inflation, it is now 3-5%. That will recede a bit as fast-moving commodity prices fall back (lumber is already down over 50% from its peak), but wages and rents, the two most important cost components, aren’t about to stop rising any time soon.
The Fed wants us to believe inflation is transitory. Some parts are. There was a temporary shortage of lumber. There was never a shortage of trees. There isn’t a shortage of oil. There was a shortage of barrels being produced. A little over a year ago, oil was below $20 a barrel. At $75 per barrel there is lots of incentive to produce. OPEC and Russia just announced agreements to start producing more. No surprise.
Let me put the bond market and inflation together. Growth since the Great Recession has absorbed a lot of excess capacity. A year from now or sooner we will be back at or close to full employment, but there is still likely to be an excess of money sloshing around. That means rates should stay low, but perhaps higher than they are today. For inflation to remain in balance, supply and demand have to grow at a consistent pace. Right now, our economy’s real growth rate is in excess of 5%, maybe closer to 10%. That will come down. There is still some excess supply, but not in the housing market, and before long not in the labor market. Thus, we face a financial world where more supply (money) keeps asset prices high, while a better balance keeps consumer prices relatively in check.
Too much money means higher prices. Because of so much excess capacity for the past decade, and therefore a lower need to invest capital, that excess showed up in higher asset prices. We have had very strong inflation. It has just happened in asset prices, not consumer prices. In a free-flowing financial world, some of the excess in assets may soon flow over to the consuming side of the economy. As home prices rise, owners will refinance, withdraw capital and spend it. Stock market investors will take profits and buy fancy cars, second homes, or fancy clothes. Even those lower on the financial totem pole have access to better paying jobs. They will increase spending as well. Can supply keep up? In the short term it couldn’t. New cars, washing machines and outdoor grills are hard to get today. Come Christmas, hot items will go faster than usual. Air travel overseas has barely begun. I would love to buy the Government’s line that inflation is transient, but it doesn’t compute in an economy getting closer and closer to full capacity.
Some inflation is good. Too much is bad. High interest rates would retard demand and allow balance to be restored, but higher interest rates could be devasting to an economy carrying record levels of debt. Monetary easing is fun at the beginning. Withdrawal is harder. We will face those consequences in the months and years ahead.
Today, actor Jon Lovitz is 64. Cartoonist Garry Trudeau turns 73.
James M. Meyer, CFA 610-260-2220