Inflation continues to be a hot topic these days and the Fed gave us a big signal on their position back in June by saying it’s “transitory”. Now we can all see inflation taking shape here in our everyday lives if you look at the steady rise in prices at the gas pump, grocery stores, across retail and of course commodities. But the question is will it hold at these elevated levels or will it come down like the Fed is saying? Well right now the market is signaling it will come down. That’s shown by looking at the 10-year yield which has been steadily decreasing to the 1.2-1.5% range since the Fed met back in June. And even before that, the yield had been coming down since March when it was at 1.75%. Now that’s certainly something to think about because you would think if prices are going up then shouldn’t the 10-year yield be too? Like what was happening earlier this year? And why is the Fed saying it’s transitory? To answer that you have to look at what inflation actually is.
It’s no more than how much money people have to spend for whatever is available to buy. How much money is a function of the money supply which the Fed controls. And of course, what’s available to buy is a function of the supply chain. Now since the pandemic began last year, the money supply grew exponentially to as high as 40% growth. It has since come down to 15% but that’s still at unprecedented levels which we haven’t seen since the 1970s. That’s crazy and any way you slice it, that simply means we have more money in the system than usual. And we all know the supply chain challenges we’ve had. So with more money and less supply that’s a double whammy for inflation which is exactly what we’ve been seeing lately with y/y CPI now being reported in the in the 5% range on the last two reads for May (5%) and June (5.4%). But as supply chain logistics improve, available goods to buy will begin to normalize back to replenished levels which will then cause inflation to come back down from current highs. That’s the “transitory” effect the Fed is referring to. But that’s not to say that inflation is going away anytime soon. Surely not and that’s where the balance between these two factors will play a big role in how it settles in. There is also another key component to keep in mind here and that is how fast money is being spent. Which is known as the “money velocity”. That also plays a part in inflation. Now that was dismally low during the pandemic and remains low to this day. But if you think about the popular finance concept of “reversion to the mean” then naturally inflation should get a boost as money begins to change hands faster. The question is when and how much it would contribute once the imbalance between money supply and supply chain settles in. That remains to be seen and that’s why everyone is so focused on what the Fed is saying these days because it’s right in their wheelhouse of their “stable prices” mandate.
So, as the economy continues to heat up, all eyes will continue to be on them and when they expect to begin a “tightening” cycle. Because even though inflation is “transitory” right now, it is certainly here to stay. And as always, the Fed will pick their spots to take action where they deem necessary. Which from observing them over the past several years it’s very apparent they are purely data driven and will react to what the data tells them. The next Fed meeting in Jackson Hole in August will definitely shed more light. This is certainly a very interesting stretch here as we continue through the summer months, and I would expect to see some moderate volatility as the market continues to process new data on the reopening cycle. Especially in light of the new Delta variant news that’s coming out. Like we saw on last Monday’s big 700-point drop on the Dow and the rest of the week in comeback mode.
We have been positioning the models we manage all year for the recovery, and we will continue to do so. Our latest rebalance on July 2 addressed this by adding exposure to consumer discretionary and bank loans, holding our positions in financials, tech and the vaccine trade and lowering duration to help mitigate interest rate risk since we expect interest rates to go up longer term.
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Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor.