Inflation Peaking, Bond Yields Bottom

Bonds are contracts for borrowers to pay back lenders and have been around since they were recorded on stone tablets in 2400 B.C. Their value is indirectly influenced by inflation and economic risk. However, with inflation indices at 30 year highs today, economic risk is being priced cheaply as reflected by the historic lows in borrowing rates. Government EuroBonds under 16 year maturities are still yielding negative interest rates for the lender.

Bond yields are more specifically determined by supply and demand.  The record supply of Government debt issuance during Covid has been overwhelmed by record demand from the quasi Government body of the Federal Reserve bank. Now that the Fed has finally committed to reducing its $120 Billion of Bond buying every month, by roughly $15 Billion less each month until they reach neutral, we are seeing some modest upward pressure on interest rates. Market consensus of forecasters expect the Fed to taper twice as fast as the Fed has stated and start raising interest rates as early as March to combat inflation. That is unlikely unless the current inflation rates of 6.2% CPI and 3.6% PCE are to rise notably from here. Our outlook assumes supply chain delays are peaking and labor supply will keep expanding toward pre-pandemic levels in 2022. This will allow for slowing rates of inflation and actual commodity deflation by this time next year, even though supply chain inflation will remain elevated over the next 6 months. The last time inflation was this high we witnessed over 8% yields in the 10 Year Treasury Note. Yet today the 10 Year is only 1.6%, despite the markets having priced in the certainty of reduced Bond demand by the Fed. The banking sector has already soared on the Government induced economic rebound and will continue to profit from rising rates in 2022.

The commercial banking system appears to be very accommodative as well with a record number of lenders loosening their credit standards for their $2.5 Trillion of Auto, Credit Card and general Consumer loans. When the net percent of banks begin tightening (above the zero% line) we would expect a more pronounced trend of rising interest rates to reduce risk and curtail consumer demand. However, we are at the polar opposite of the tightening cycle today.

There is little the Government can do at this stage other than stopping all of the proposed stimulus spending that keeps the digital printing presses flooding the economy with excess demand and inflation. The public relations (PR) gimmick of releasing 50 million barrels of Oil from Strategic Petroleum Reserve (SDR) will not have any effect on oil prices, even if Oil prices fall from here. A couple weeks ago our newsletter forecasted the recent sharp decline in Oil that was due to seasonal factors and inventory builds. This PR effort will have no effect on inflation, even though we continue to see underlying inflation peaking . Ocean shipping rates have fallen, iron ore, lumber and other commodities are down sharply. A glut of Oil is expected next Spring and the equaly vital shortage of semiconductor chips is expected to move toward surplus in the 2nd half of 2022.

Banking and financial stocks have performed well in this Covid Bull market and should outperform should interest rates break out in 2022.

Barring a premature economic downturn due to a tighter Covid lockdown in the US and Europe, this 20 month old equity Bull market should persist in 2022. A 12 to 15% correction is long overdue, but until the Global economy is able to open in a post pandemic environment without Government support, it’s risky to bet on a broad based stock market panic in the near term. We expect interest rates to rise into the end of February above 1.75% on the 10 Year during a period when the US Treasury is likely to be increasing its debt issuance (supply) at a faster pace. A broad based portfolio of lagging small cap and cyclicals along with large cap growth, energy and financial stocks is still necessary in this Bull market as we inexorably climb toward a full economic recovery without material Covid restrictions.

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