WEEK ENDING 11/22/2024
- Are we in a temporary inflation lull?
- Will the next administration’s policies raise inflation?
- White meat or dark? Happy Thanksgiving from all of us.
A CITY DIFFERENT TAKE
Given Trump’s upcoming policy guidance, there are reasons to believe that inflation could soon be on the rise. This begs the question, “Are we in a temporary inflation lull?
To answer that, let’s recap our current economic cycle of inflation starting in 2020, breaking down two waves of inflation: one led by demand and the other led by supply. Then, we’ll look at what impact Trump's policies could have on a potential third wave of inflation.
Let’s start by saying this: forecasting the dynamics between monetary and fiscal policy is speculative. The Federal Reserve, like all economists and market pundits somewhere, believes that the new president’s policy choices will be inflationary and are perhaps giving themselves hedging room to not err in advance.
We experienced the first wave of inflation in this current cycle created by demand imbalance, led by the outbreak of COVID-19 in 2020. This was supplemented by a massive governmental stimulus.
The second inflation shock came with a deteriorating supply side. The world supply-demand imbalance was still reeling from closed borders caused by the pandemic. The Russia-Ukraine War deepened the supply imbalance starting in February 2022.
The Fed, in one of the fastest rate hikes in history, somewhat threaded the proverbial needle of a soft landing by June 2024. We have been experiencing a lull in inflation as measured by the traditional metrics of CPI and core PCE. Current inflation, as measured by core PCE, is at 2.7%, which is not much further from the Fed’s 2% inflation target. Clearly the Fed believes that policy is close to restrictive, resulting in 75 basis points of rate cuts (with speculation of another cut of 25 basis points in December). To us, this reveals that the Fed is more comfortable operating in an inflation target band of 2–3% instead of a strict 2% mandate. Also, with further hedging guidance from the FOMC and Chair Powell himself, that rate cut will be gradual.
Now comes President-elect Donald Trump with a resounding mandate to the Republican party. The wild card for the markets is how Trump’s policy choices will shape the economy moving forward. We have talked before about the impact of inflation based on policy decisions that seem to be pro-inflationary.
Is there a third wave of inflation waiting for us behind the currents of 2025? With all this build-up, we have an anti-climactic answer: we don’t know. Forecasting the impact of policies on the economy is tricky at best. From the current vantage point, we are leaning toward “yes, policy impacts could be inflationary.” For instance:
- Even if there is no mass deportation, immigration will slow. This affects the labor market and creeps into GDP.
- Tariffs on Chinese imports could be up to 60%, which would cause price escalations a decline in growth.
We think that the monetary policy rate and the Federal Reserve's search for r-star will result in a higher, longer-term rate because of the FOMC's more cautious approach.
CHANGES IN RATES
The Treasury market was somewhat steady, with the 5–30 section of the curve slightly lower in yield.
The municipal curve was slightly lower in all tenors.
Municipals, as measured as a ratio versus their Treasury equivalent maturities, look unattractive as they have moved even lower.
Changes in corporate yields were mixed last week.
THIS WEEK IN WASHINGTON
President-elect Trump continues to shape his Cabinet. Notable nominations include Brooke Rollins for agriculture secretary, Howard Lutnick for commerce secretary, and Scott Bessent, who runs a macro hedge fund called Key Square Group, for treasury secretary. Vice President-elect JD Vance has been working to help pass the Cabinet picks through the Senate.
The most controversial of Trump’s picks thus far has been Matt Gaetz for the position of attorney general. Getting Senate support for the nomination was already contentious, leading Gaetz to withdraw. Trump quickly nominated former Florida Attorney General Pam Bondi as a replacement.
Abroad, the US is continuing to help negotiate a possible ceasefire agreement between Israel and Hezbollah. This could help calm regional tensions and prevent further expansion of the war into other countries.
WHAT, ME WORRY ABOUT INFLATION?
The 5-year Breakeven Inflation Rate finished the week of November 22 at 2.43%, 16 basis point higher week over week. The 10-year Breakeven Inflation Rate also remained flat, finishing at 2.34%, 1 basis point higher than a week ago.
MUNICIPAL CREDIT
As of November 22, 10-year quality spreads (AAA vs. BBB) were 1.02%, 12 basis points higher than the November 15 reading (based on our calculations). The long-term average is 1.70%.
Quality spreads in the taxable market are not attractive. They ended slightly tighter at 0.73%, 2 basis points tighter than the prior week. High-yield quality spreads were 7 basis points higher at 2.51% compared to the week before.
Corporate bond spreads are really tight, and corporate bond CDS have seen some growing interest. According to data compiled by S&P Global Market Intelligence, corporate bond shorts are at $336 billion.
WHERE ARE FIXED-INCOME INVESTORS PUTTING THEIR CASH?
Money Market Flows (millions of dollars)
Money market funds were mixed last week with the biggest drop in flows in government funds.
Mutual Fund Flows (millions of dollars)
Cash flows into bond funds were mixed last week. Significant among these were net outflows in government funds.
ETF Fund Flows (millions of dollars)
ETF asset classes saw a net decline in flows week-over-week.
SUPPLY OF NEW ISSUE MUNICIPAL BONDS
The supply of new issues is starting to dwindle. Projections for the month of December currently stand at close to $3 billion. Supply for the short holiday week is at $1.4 billion in municipal bonds.
CONCLUSION
In this shortened holiday week, we recap the current inflation cycle, which started in 2020, and recount the two distinct waves of inflation. We are concerned that we are currently lulled by a pause in inflation in light of pro-inflationary policies ahead.
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