Taper Time…Again

The U.S. consumer price index (CPI) surged to 6.8% in November.

This is the highest inflation print since June 1982. However, most of the price gains remain centered in the commodity complex with commodity prices up 12% year-on-year while services prices are up a more modest 3.8%. Core inflation, which excludes food and energy prices, is up 5.0%. The Atlanta Fed’s “sticky CPI” metric, which reflects the prices of categories that tend to change more slowly over time and better reflect longer-lasting inflationary trends is up a more subdued 3.4%. Either way, the latest inflation print likely supports the Fed’s view that it should accelerate the end of its bond purchase program.

Scientific results of lab studies of the omicron variant continued to roll in.

One major vaccine maker reported that a third dose of their vaccine may be needed to neutralize the omicron variant. A separate UK study suggested that boosters may provide 70% to 75% protection from omicron. While encouraging, it appears that the variant may be more transmissible than the delta variant with the UK reporting its first omicron-related death and an increasing number of related hospitalizations.

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All eyes will be on the Federal Reserve this week with investors waiting to hear if the Fed will decide to accelerate its pace of bond purchase tapering from the current pace of $15 billion a month ($10 billion in U.S. Treasuries and $5 billion in mortgage-backed securities) to perhaps $30 billion a month. The odds of this likely rose following the November release of the consumer price index (see figure 1).

This chart shows the U.S. Consumer Price Index Year-on-Year Percent Change from 1960 to 2021 Year-to-Date. Persistent inflation could choke off growth if the Fed is forced to tighten policy too quickly.

By potentially doubling its pace of tapering and ending its quantitative easing (QE) program early, the Fed will presumably be able to more easily raise rates should it need to address persistent inflation. Whether the Fed decides to hike rates immediately following the completion of the QE program will depend on the path of inflation and economic growth at the time, but it looks like the Fed may be on the path to hike rates for the first time during this expansion by either the second or third quarter of 2022. Though the spread of the omicron variant could potentially delay this should it begin to weigh on temporarily growth in early 2022.  

One side effect of these expectations is that the yield curve (the difference between the 10-year U.S. Treasury yield and the 2-year U.S. Treasury yield) has been flattening with short-term rates rising while longer-term rates show a more muted response as investors may believe that high inflation may eventually lead to weaker growth if the Fed starts to tighten monetary policy. However, this could eventually reverse should inflation start to moderate in 2022. Interestingly, long-term inflation expectations may already be starting to reflect this with the 10-year U.S. Treasury breakeven rate, which is the difference between the real yield and the nominal yield and acts as a gauge for long-term inflation expectations, declining steadily since mid-November (see figure 2).

This could be also be reflecting the recent slowing in commodity prices gains (see figure 3) and growing expectations that base effects alone in March and April of 2022 (meaning that March 2022 data will be compared to March 2021’s data) will likely begin to drag down the inflation rate. This supports Citi Global Wealth Investments’ view that U.S. inflation will fall to about 3.0% in 2022.

This line chart shows the 10-Year U.S. Breakeven Rate in percent from January 2020 to 2021 Year-to-Date.

This line chart shows the S&P GSCI Commodity Spot Index from January 2020 to 2021 Year-to-Date.

Importantly, the flatter yield curve is likely one of the primary reasons that financial sector stocks have underperformed recently (see figure 4). It should also be noted that financial sector stocks have had a very strong run and it would not be surprising to see gains moderate as the sector has already rebounded materially. This type of trend coincides with the retirement of our prior year’s investing theme of “mean revision.” Moving forward we think that sectors like Healthcare and Consumer Staples may become more in vogue as investors tilt towards quality companies with strong balance sheets and sustainable dividend growth.

Although portfolio adjustments may be needed heading into 2022, we expect the economic expansion to endure and would like to remind investors that initial Fed rate hikes often do not equate with the end of bull markets. If we look at U.S. market performance after the last nine first Fed rate hikes, the S&P 500 gained an additional 35% over the next two years on average (see figure 5). While abrupt changes to Fed policy could easily rattle markets and spark volatility, history suggests that the bull market likely still has a lengthy runway ahead.

Congress Swerves Yet Again

Lastly, Congress removed a key risk to financial markets by acting to modify the debt ceiling last week with Senate Minority Leader Mitch McConnell and 13 other Republicans siding with Democrats to avoid a Federal default. The 64-36 vote advanced a measure that will allow the Democrats to bypass the 60-vote filibuster requirement for a one-time bill to lift the debt ceiling limit.

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