This past week, the Bureau of Labor Statistics (BLS) released its much anticipated inflation figures for January. No one was expecting prices to fall, as they did in December. Investors just hoped the data would be mild enough for the Fed to stop hiking rates sooner rather than later.
Unfortunately, they didn’t get their wish.
Both the Consumer Price Index (CPI) and Producer Price Index (PPI) were disappointingly high. The CPI was up 0.5% last month, and the PPI rose 0.7%. As a result, the trailing 12-month numbers remained elevated at 6.4% and 6.0%, respectively. Essentially, any hope of the Fed cooling its heels after the FOMC meeting in May vanished. So much so, the markets are now anticipating an additional 25 basis point (0.25%) hike.
Interestingly, the stock market didn’t really seem to respond to the data until late in the trading day on Thursday. In truth, if Federal Reserve Bank of Cleveland President Loretta Mester and St. Louis President James Bullard hadn’t run their mouths the way they did, stocks were basically flat yesterday. Basically, investors had mostly looked past yesterday’s inflation data until the bureaucrats tased them.
But why was this time different?
First, whenever I say something is different this time, I usually find out it isn’t. Further, a couple of trading doesn’t necessarily make a trend. However, I would submit investors have finally come to the logical conclusion the Fed is probably closer to the end of its tightening cycle than the beginning. If that is indeed the case, folks can better plan for the future.
In this instance, this is more important than the absolute level of interest rates. After all, they are nothing more than the price of money in the economy. If you borrow money at 5% but can generate a 9% rate of return, would you do it? Of course you would. Further, the U.S. economy was somehow able to grow in the past in interest rate environments that were much higher than today’s.
Consider this. Going all the way back to January 1962, the average month-end yield to maturity on/for the 10-Year U.S. Treasury was 5.89% through the end of last month. It was 3.51% at the end of January 2023. So, it is hard to say the absolute level of interest rates alone will kill the economy. Obviously, an increase in rates could cause economic activity to cool, which it has, as the demand for money slows.
However, this should last only until the economy has time to adjust to the new equilibrium prices/interest rates in the financial system. If that sounds like your Econ 101 class, it sort of is. Further, with the trailing 12-month CPI currently running at 6.4%, it is hard to argue relative rates are too high with the 10-Year Treasury less than 4%.
Then, there is the contention that higher interest rates ultimately led to higher returns in general. This makes sense, believe it or not, as more expensive money inherently requires a greater amount of risk taking. As anyone in the investment industry can tell you, the more risk you take, the more return you should receive.
Let’s think about it. Going back to the 1920s, there has been an average “equity risk premium” of roughly 5%. That is the essentially the difference in return between intermediate-term government bonds and U.S. stocks. Put another way, it is the premium investors demand for taking, drum roll please, equity risk.
With this in mind, if borrowing rates are, say, 2%, investors might be happy with a project that generates a 7% rate of return. Hmm. Is it any wonder we have seen such a proliferation in restaurants and coffee shops over the last umpteen years? However, if money costs 8%, investors are going to demand a return of roughly 13%.
It will require a little something extra in order to get there in absolute terms, namely profit and growth. In other words, it will require more risk taking. Essentially, higher interest rates, to a point, foster higher returns, greater risk taking and higher returns.
If you find that difficult to follow, please consider the Japanese. The 10-Year Japanese Treasury note has had an average yield to maturity of around 0.75% over the past 30 years. IF low interest rates were the panacea for what ails an economy, Japan should have grown by leaps and bounds over the last three decades. Am I right?
However, almost the exact opposite has happened. Lower interest rates have crushed risk taking.
Almost coincidentally, perhaps, the straight average of annual, real GDP growth in Japan has been 0.75% over the last 30 years. By comparison, the same measure was 2.46% in the United States. Compound that difference over 30 years, and you have a yawning difference in economic activity. How does 66.3% sound to you?
Therefore, I would contend the absolute level of interest rates doesn’t matter as much to investors as knowing they won’t go significantly higher in the short term. Basically, stability and visibility are soothing balms to frayed nerves. For whatever reason, the recent data again has investors believing we are closer to the end of the tightening cycle than the beginning.
This is the best way I can wrap my brain around the reversal in investor psyche. This week’s inflation data would have given the markets heart palpitations not so long ago. However, this week? Through Thursday, I suppose you could say, “meh.”
Of course, we aren’t out of the proverbial woods yet. The markets won’t be so cavalier, sanguine or whatever if there isn’t more tangible evidence of slowing inflation. After all, that would imply the Fed would keep on raising interest rates. Obviously, that would tear apart that which investors crave — and what I just wrote — stability and visibility in the near term.
Over the longer term, things could get really interesting over the next decade. While this time could be different, expect to see some clever stuff happen as the potential for higher absolute returns increases.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this and every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist & Cynic
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.