Either inflation and inflation expectations need to come down OR interest rates need to go up…
Markets in the Red.
This week was the pits in the markets, with plenty of red ink to go around. So much so, Cincinnati is thinking about renaming its baseball team to the “Third Week in Augusts.” Hey, if Cleveland can name its team after some statues on a bridge, no kidding, Cincinnati can do this.
Personally, I thought Rockers, as opposed to the Guardians, would have been a great name due to the Rock & Roll Hall of Fame being in the “Mistake on the Lake,” my birthplace. However, no one asked me.
The reason(s) for this week’s unpleasantness was higher interest rates.
In fact, they have been to blame all month. I could make it more complicated than that, but why would I?
- At the end of July 2023, the yield to maturity on the 10-Year US Treasury Note was 3.97%.
- At the close of trading yesterday, 8/17/2023, it was 4.28%.
While that might not sound like much movement to the outside world, this is a pretty steep increase in a short period of time.
But why?
You could point fingers in a number of different directions, but you would always come back to the following: because investors demand a rate of return in excess of inflation. That isn’t too hard to grasp, is it? I mean, who wants their purchasing power to diminish? To have inflation eat into their principal?
No one does.
Going back to the 1920s, and rounding like nobody’s business, the return on intermediate-term government bonds has been around 5.0%. This will vary every year depending on the annual rate of return. By comparison, inflation has averaged around 3.0%. As such, you can see why reasonably intuit investors have historically expected a 2% real rate of return, roughly, over intermediate government debt.
Currently, 10-year inflation expectations are the difference between the ‘cash’ 10-Year Treasury Note and its Treasury Inflation Protected Security (TIPS) equivalent. As of 1:26 CDT PM on 8/18/2023, the equation would be: 4.253% – 1.931% = 2.322%. Voila.
So, if we pull in that historical 2% spread, the yield to maturity on the 10-Year Treasury should actually be 4.322% instead of 4.253%. Obviously, that is only a 7 basis point disparity. So, the markets must be pretty efficient, huh?
It depends. This is only one way to measure inflation expectations.
For instance, the University of Michigan conducts a monthly survey tracking consumer sentiment. One of the gauges is the “expected change in prices during the next 5-10 years: median.” The historical average of this component is 2.8%, which is obviously closer to 3.0% than it is to 2.32%. Last month, it was 2.9%.
Therefore, if the good folks in Michigan are more accurate with their inflation estimate than the Treasury market, and that is a big IF, the yield on the 10-Year Treasury Note should be around 4.9%.
Bleah.
For those who prefer things in black and white: the trailing 12-month Consumer Price Index for July 2023 was 3.2%. Tack on that 2% necessary real rate of return and, abracadabra, the 10-Year should be trading at 5.2%. If this is the most accurate method of calculating 10-year interest rates, bond investors are in for some more pain.
Specifically, 10-Year Treasury Note holders could reasonably expect about another 8% drop in the principal value of their investment. That is just the way the math works.
Can I get a bleah and a yuck?
Make no mistake about it.
Either inflation and inflation expectations need to come down OR interest rates need to go up.
Since you almost always find the truth somewhere in the middle, I could very easily make the following statement/argument:
“Assuming there aren’t any black swan events, and there always seems to be one, the yield to maturity on the 10-Year U.S. Treasury Note could eventually find a home in the 4.50-4.75% range, plus or minus a few basis points.”
To be sure, this is a vague prediction with all sorts of qualifications and weak verbs. It is what we do. However, it is also defendable and, dare I say it, reasonable after close to 15 years of monetary policy foolishness.
By foolishness, I mean persistently accommodative, seemingly politically motivated, monetary policies meant to avoid economic unpleasantness. Sustained negative real interest rates. Blowing up the Federal Reserve’s balance sheet. That sort of stuff. You can liken it all to giving a gallon-sized milkshake to someone with insulin resistance.
But let’s think about this for a second. If there has been, indeed, 15 years of monetary policy foolishness, this means, for all intents and purposes, investment managers under 40 haven’t experienced normalcy in their careers. Aberration, if that is the opposite of normal here, is all they have known.
Kids these days, huh? Ha. However, there I go again, being a know it all.
No, I don’t know everything. A lot of what I do is simply playing the odds, knowing historical averages and respecting correlations. There is some mathematics in there, too. With that said, there is at least one thing I know. This being Rockers would have been a much better name than Guardians for the Cleveland baseball team.
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 any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
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.
