Market commentary | June 2023
"The most terrifying words in the English language are ‘I’m from the government and I’m here to help.' "
– Ronald Reagan
Our contention has been that both inflation and the economy were gradually softening and that the cumulative effects would be sufficient to induce the Federal Reserve (Fed) to pause its tightening program. The downward path of inflation has been uneven but persistent. The rate of inflation has moved from 9.1% year-over-year (Y/Y) to 4.9% Y/Y since last fall, making back over half the distance to the Fed’s ultimate 2% target. Using current rental and housing data, the core Consumer Price Index (CPI) has been running between 0% and 2% over the last six months (Exhibit 1). And this comes even as the lags from the enormity of the Fed’s interest rate tightening campaign are still before us. The economy has proved reasonably resilient with only a modest slowdown to date. But downside risks are becoming more dominant, as credit conditions tighten in the wake of the regional banking crisis.
Exhibit 1: Inflation Trending Lower—Persistent but Uneven
Source: Bureau of Labor Statistics, ApartmentList.com, Western Asset calculations. As of April 30, 2023.
The Fed has signaled a willingness to stop hiking—but has conditioned this as a “hawkish pause.” This means market participants are still at the whim of monthly data prints as the Fed’s lip service to “long and variable lags” continues to be more form than substance. This is extremely unfortunate for two reasons. The first is simply that there are long and variable lags in monetary policy and the massive Fed interest rate shock of 500 basis points (bps) of tightening may already be too much. Second, the violence in the fixed-income markets has become enormous. Exhibit 2 shows the change in yield on the 2-year Treasury note just this year. We had a 35-bp rally in early January as inflation data ebbed, and the Fed intimated it might be done. On February 8, Powell said, “... it is gratifying that the disinflationary process is getting underway. We’re going to be cautious about declaring victory ....” So the Fed’s message was that it could, but wouldn’t declare victory.
Exhibit 2: Yield on the 2-Year Treasury Note
Source: Bloomberg. As of May 31, 2023. Past performance is not an indicator or a guarantee of future results.
Four weeks later, the yield on the 2-year Treasury note had risen by 65 bps. Powell then completely reversed, testifying before Congress that the Fed would need to accelerate to 50-bp hiking moves because inflation was now dangerous and the Fed might be behind the curve. As the regional banking crisis perhaps not coincidentally exploded the day afterward, 2-year Treasury note yields fell virtually 112 bps on just five trading days. Market reactions signify the clear understanding that the enormity of this tightening campaign could give way to a downside break, but if not, even further Fed tightening cannot be ruled out.
Such is now the case. The 2-year Treasury note yield has risen 78 bps from its low. Why? The economy has remained resilient, and inflation continues to be “sticky,” which is code for not coming down fast enough. The Fed remains fixated on the labor market and monthly inflation data. While both are lagging indicators, and would reasonably be expected to face the downward pressures from policy lags and tightening credit conditions, Fed policy tightening continues to be a month-by-month decision. Markets are beset by both the direct upside yield risks of tightening, and the downside yield risks from potential economic damage.
The inconsistent communication and messaging from the Fed has elevated our concern for a policy error, thus increasing the likelihood of more negative economic outcomes. Although our base case remains a moderate slowdown, we have biased our credit positioning toward higher quality. We maintain that a higher-quality credit profile will still capture meaningful upside in our base case scenario, but prove resilient should more challenging economic headwinds prevail. Additionally, we have moved our duration more to the front end of the yield curve. We still believe the fundamentals strongly suggest a hard landing is both improbable and unnecessary.
On a brighter note, our contention remains that when the history books are written, the Covid inflation spike will prove to be an anomaly. The enormity of both the Covid and Ukraine war supply-side disruptions are now past. Commodity prices have been falling broadly and steadily. The fiscal policy expansiveness has reversed and future forays have been shelved by the debt limit compromise. Most importantly, monetary policy is straightforwardly contractionary. Exhibit 3 shows that M2 growth has now contracted at a 4.63% rate, which is the greatest contraction since the Great Depression. Granted, M2 was expanded spectacularly, swelled by the enormity of transfer payments related to the pandemic, but the speed of this reversal suggests future inflation will be much lower.
Exhibit 3: Money Stock (M2)
Source: US Treasury, Haver Analytics. As of April 30, 2023.
Last week, former Chair of the Federal Reserve, Ben Bernanke, and former chief economist at the International Monetary Fund, Olivier Blanchard, presented a new paper at the Brookings Institution entitled, “What Caused the US Pandemic-Era Inflation?” Their conclusion was that supply-side issues were the predominant drivers of the inflation, rather than demand policy overreach. Pushing back against the idea that inflation was policy-driven, they wrote, “The critics’ forecasts of higher inflation would prove to be correct—indeed, even too optimistic—but in substantial part, the sources of the inflation would be different from those they warned about.” We have steadfastly articulated the supply-side challenge of the inflation bulge. While it is nice to be in such august company, more importantly, the supply shock unwind should be beneficial to both sturdier growth and lower inflation.
Additionally, to get out of our lane, the market preoccupation with artificial intelligence (AI) should also have a disinflationary note. As Jeremy Siegel puts it, “While gains from AI will be uneven throughout society and the economy, it has the potential to be very deflationary by reducing costs and the need for labor.”
Across the fixed-income spectrum, investors have choices that offer much more yield than has been generally available over the course of the last 15 years. But investors are reasonably nervous about today’s potential downside economic risks and upside yield risks as the Fed tightening campaign threatens to rumble on. However, we believe the longer view mandates taking advantage of a declining inflation trajectory by embracing today’s yields.
Definitions
One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
The Consumer Price Index (CPI) measures the average change in U.S. consumer prices over time in a fixed market basket of goods and services determined by the U.S. Bureau of Labor Statistics.
M2 is a measure of money supply that includes cash and checking deposits (M1) as well as near money. “Near money" in M2 includes savings deposits, money market mutual funds and other time deposits, which are less liquid and not as suitable as exchange mediums but can be quickly converted into cash or checking deposits.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
CONTRIBUTORS
Kenneth Leech
Chief Investment Officer
Western Asset
Related Content
Explore Western Asset Insights
Federal Reserve addresses both financial stability and inflation risks
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal.
Data from third party sources may have been used in the preparation of this material and Franklin Templeton ("FT") has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com - Franklin Distributors, LLC is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
You need Adobe Acrobat Reader to view and print PDF documents. Download a free version from Adobe's website.
Franklin Distributors, LLC
This website is intended for residents of the US.