It’s Valentine’s Day. We’re confident you didn’t open this blog in search of relationship advice, so we’ll stick to the script and draw your attention again to inflation. As the markets continue to focus on inflation, I thought it might help to dig a bit further into where this inflation is coming from and why we think the inflation rate is peaking. Before we get into the numbers on inflation, let’s take a look at COVID cases to see when the economy really started to reopen (basically when the first wave of cases peaked and started to come down).
You can see that peak was in late January 2021. Things started opening up and people started doing things and going places after that. So, let’s take a look at the month over month inflation to see if that corresponds to COVID cases easing.
You can see that starting in February 2021, inflation started to move up as activity increased, people started doing things again and we started to hear about ‘supply chain constraints.’ Next, let’s take a look at the recent inflation report to see where the inflation is coming from.
If you like pictures rather than data tables, here’s one from Goldman Sachs that looks at roughly the same data:
As you can see in the table, the biggest contributors to the monthly inflation numbers are still used vehicles and energy on a 12-month basis. If we look closer, we see that both of those categories ticked down for the month of January. Will that continue? Not sure, but I don’t think we are going to see energy up another 30% over the next year or used cars going up another 40%. If energy does go up that much, you will start to see consumer behaviors change. There will be less driving thanks to higher prices. You won’t so much mind the upcoming Amazon Prime membership price increase, as sitting on your couch to order your goods will seem much more attractive than yet another trip to the store in your SUV. Candidly, I don’t foresee another major spike in energy prices, but I fully recognize that, in the short run, the issue in Russia/Ukraine will likely keep oil high, so that may hold that part of inflation at elevated levels.
As the FED continues to yap about raising rates and are getting pressure from politicians to “control” inflation, we see an inflation rate that is peaking and will likely be much lower six months from now. So, then the question becomes will the FED get too far out over their skis, or will they take a more measured approach? I would say at this point, the market has done much of the work for the FED. Take a look at the 2-year Treasury below.
You can see that the rate has gone from about 0.2% to over 1.5% over the last 4 months or so. Meanwhile, the 10-year Treasury hasn’t move much at all. We have shown the 10/2 Treasury spread before, which is a good indicator of recessions in the future. That has narrowed considerably. See below.
So right now, the spread is basically 40 basis points (bps), or 0.4% between the 10 year and 2 year. Not warning of a recession yet but going in the wrong direction if the FED gets really aggressive raising rates. If, however, the FED raises rates less than what is already factored into the markets (currently about 1.25% or 5 quarter point raises), the market could be setting up for a nice rally in the second half of the year. We shall see.
I’ll shut it down for today and wish everyone a Happy Valentine’s Day! Buy your sweetie something sweet. Have a good week and please do reach out with questions, comments, or concerns. Next week, we’ll take a break from the markets and resume our installments on financial planning topics that we find relevant and interesting. This one will be on capital gains and your home.