Last Week It was a tale of two worlds last week. In the rates markets, more and more participants have begun to accept as fact that the inflationary pressures being experienced in all corners of the e...
You can almost hear the nervous laughter reverberating across financial markets with the jump in yields on the longer end of the yield curve. Since the end of January, yields on the 10-year Treasury note have jumped over 25 basis points, blasting through the 1% barrier.
The spread between the two-year and 30-year points on the curve have increased to approximately 27 basis points over the same period. The curve movement almost seems like a long-lost friend we used to call normalcy! The front-end of the curve is fully anchored in current Fed monetary policy, while the long-end is predicting the long-awaited reflating of the economy.
However—are we there yet? It seems apparent that we will experience what has become to be known as a “K-Shaped” recovery. The K recovery essentially is a further widening of the nation’s wealth gap. If you were able to keep your job, refinance your mortgage, and ride the equity market rocket ship, financially you are probably in better shape than before COVID-19, and you have an awful lot of pent-up demand to get out and spend like a drunken sailor! However, if you lost your job, do not own a home or financial assets, your financial condition—which was not so hot going into COVID-19—has gotten dramatically worse.
Will the Fed allow for much inflation as the K-shaped recovery becomes more apparent? We believe the answer is yes. Many Fed governors and bank presidents have stated that they will let the economy run hot by keeping a zero-interest rate policy in place. The January FOMC statement and the subsequent minutes of that meeting made it very clear that the Fed is nowhere near raising rates or tapering the $80 billion Treasuries and $40 billion Agency MBS they buy each month.
The Fed, going back to when the current Treasury Secretary was the Chairwoman of the Fed, has been pleading with the Federal Government to share the load in stimulating the economy and reducing the wealth gap. President Trump’s 2017 tax cut definitely stimulated the economy; however, it was a traditional trickle-down policy which, after a relatively short period, did not change the direction of the nation’s wealth gap. Now, with President Biden, he should pay attention to lifting the fortunes of those going the wrong way on the K diagram. Some might call this social engineering. However, one could argue that we have been in a social engineering program for decades, with seemingly everything directed toward inflating financial assets and generating corporate profits for the benefit of the few, and to the detriment of the many.
Now that it appears the Fed will get what they have been asking for—greater fiscal stimulus and deficit spending—their task is a very tricky one. How do they get what they want and stop the longer end of the yield curve from spiraling out of control?
Additionally, we have to ask ourselves, is the yield on a 10-year Treasury going from 1.35% to 2% really “out of control”? For financial assets, sharply rising rates can pop the amazing bubble ride that we have been on since the Fed and Treasury massively intervened last March (not to mention 12 years earlier).
Whether it be municipal bonds, investment-grade, and high-yield corporate bonds, or many stocks and other alternative assets, every risk asset is at or near all-time highs. If the bubble was inflated by rock-bottom risk-free rates, as opposed to fundamentals, should the holders of the bubble be rescued once it pops as the result to the normalization of rates?
President Trump used to yell to his admirers, “How’s your 401k?” He may not have noticed, but there were an awful lot of people in the crowd who have never had a 401k. Therefore, if rates rose to the point of popping financial asset bubbles as the result of spending programs that benefit the holders of the short-end of the economic stick, would the Federal Reserve and the White House go along and not bail financial assets out? Should markets that cannot take a 2% or 3% 10-year Treasury yield be bailed out? Moreover, if the banking system cannot handle a 3% 10-year, then an awful lot of powerful people have not been doing their jobs.
Financial asset hyper-inflation has only helped those who hold financial assets. The thought of meaningful benefits trickling down to the vast majority of Americans who live paycheck to paycheck is absurd. President Trump was onto a lot of things, which is why he got elected in 2016, and this was a big one. Unfortunately, he consistently lost focus. However, his oft repeated, “Jobs! Jobs! Jobs!” was no joke. Say what you will, but he was trying to get good-paying jobs back to the USA with his trade wars. If President Biden continues the movement to bring high-paying jobs back to America and raise the minimum wage to $15 at the expense of corporate profits and risk asset valuations, it may be politically the right thing for him to. The Democratic Party is trying to win back what was once a key pillar of their base, the pillar that left them to give something different a chance in 2016.
We think the reflation trade is here. Be prepared.
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