by Liz Ann Sonders, Jeffey Kleintop, Kathy Jones, and Kevin Gordon, Randy Frederick, Charles Schwab & Company Ltd.
As 2021 draws to a close, there are signs that the new year may be better than the last. The direction of COVID-19 variants remains difficult to predict, but another recent fear that has bedeviled the markets—inflation—may be about to ease. Treasury bond markets are sending a message that the Federal Reserve may not have as much scope to raise short-term rates as its forecasts suggest, and Congress has reached a deal that postpones the debt ceiling issue until 2023.
U.S. stocks and economy: Pressures may be easing
As 2022 approaches, investors are looking forward to a potential easing in the pressures that muddied the economic outlook during 2021, including inflation. While consumers haven’t yet reined in their spending—U.S. retail sales increased by 0.3% in November, the fourth monthly increase in a row—the proportion of consumers planning to make major purchases over the next six months remains depressed.1
Much of the souring in buying sentiment is due to the broad increase in inflation this year. As you can see in the chart below, not only has the Consumer Price Index (CPI) increased at a 6.8% annual rate—the fastest since 1982—but the CPI components associated with the economic reopening after COVID-19, such as car prices and airfare, have become bigger contributors to overall inflation after seeing their impact wane throughout the summer.
Return of the “reopening” components
Source: Charles Schwab, Bloomberg Economics, Bureau of Labor Statistics (BLS), as of 11/30/2021. Reopening components include used cars/trucks, rental cars/trucks, vehicle insurance, lodging, airfares, and food away from home.
In the second quarter of the year, reopening components’ prices surged mostly due to supply-related bottlenecks; thus, their resurgence suggests that we are not yet out of the woods with kinks in the global supply chain.
Fears about higher and persistent inflation have been well telegraphed by consumers, but some market measures have adopted a more sanguine tone. As shown in the chart below, the 5-year, 5-year U.S. dollar inflation swap rate—which measures the expected average inflation rate over the five-year period that begins five years from today—has moved lower from its recent high of 2.6%. Another measure, from the University of Michigan, implies that consumers expect inflation to settle at 3% over the same time frame—markedly lower than the current rate of 6.8%.
Fear not, says the market?
Source: Charles Schwab, Bloomberg, as of 12/15/2021.
Both metrics are well below their highs during the 2007-2009 global financial crisis. Although they are signaling a higher floor for inflation (relative to before the pandemic) in the long run, it isn’t anything close to the stagflation seen in the 1970s-1980s. We think a repeat of that era is unlikely, given that supply-related factors are coming into balance, the “base effect” for goods prices will likely become more favorable during the first half of 2022, and commodity prices have already eased a bit.
Certain segments of the stock market have started to take notice of the prospect for higher prices and rates in the future. Notably, low-quality, speculative stocks have taken a hit over the past month. As you can see in the chart below, a cohort of non-profitable tech stocks has deteriorated markedly since February. Since the beginning of 2020, their lead over the more fundamentally-sound S&P 500 Information Technology Index has been cut to just over 50%.
Performance of low-quality, speculative tech stocks has declined
Source: Charles Schwab, Bloomberg, as of 12/15/2021. Data indexed to 100 (base value = 1/1/2020). The Goldman Sachs (GS) non-profitable technology basket consists of non-profitable U.S.-listed companies in innovative industries. Technology is defined quite broadly to include new economy companies across GICS industry groupings. Past performance is no guarantee of future results.
The narrowing of that performance gap emphasizes our strong bias toward high-quality factors such as strong earnings revisions, balance sheets, and cash flow. With sector swings and rotations still rampant, maintaining a factor-based (as opposed to sector-based) approach should allow for more stability and less violent swings in portfolios.
Global stocks and economy: Peak inflation fear
Inflation in the eurozone surged to 4.9% in November, the highest in its 23-year history. In response, the market is pricing in a greater-than-50% chance of a European Central Bank (ECB) rate hike by the end of 2022. However, we believe the likelihood is far less than 50%, as by year end inflation likely will have slowed to below 2%. As inflation recedes, the market’s outlook for rate hikes is likely to fade.
The peak in inflation fear may be about to pass. In fact, by some measures it already has. The ZEW investors’ eurozone inflation expectations index has dropped sharply in the past three months, turning negative to a degree only seen in recessions over the past 25 years, as you can see in the chart below. This sharp drop in investors’ inflation expectations could be an important turning point for inflation fears.
Eurozone inflation expectations take a dive
Source: Charles Schwab, Bloomberg data as of 12/9/2021. Values reflect the percentage of those expecting higher inflation minus the percentage expecting lower inflation, where above zero means most survey participants expect prices to rise and below zero means most expect prices to fall.
Although 2021 saw extraordinary upward pressure on inflation from energy prices, 2022 may see the opposite. Energy contributed about two-thirds of the rise in eurozone consumer price inflation in 2021, which may make it the most important factor for determining what happens next.
Most of the surge in inflation is driven by energy
Source: Charles Schwab, Macrobond data as of 12/9/2021. No breakdown was yet available for November 2021.
We believe European inflation is likely to slide from a record high of around 5% at year-end 2021 to below the ECB’s 2% target by the end of 2022. Let’s look at three scenarios for inflation under different energy outcomes:
- Energy prices rise: Energy market futures prices (including electricity and natural gas) for year-end 2022 point to a 30% drop from current prices, the mirror image of the 27% increase in energy prices in CPI from a year ago. Using these futures prices, we estimate that overall Eurozone inflation would drop to around 0% in December 2022, as energy goes from a big positive contributor to a big drag on overall inflation.
- Energy prices stabilize: If energy prices stabilize at current levels, we estimate that overall inflation would end 2022 around 2%. It would take a further climb in energy prices beyond the rise in 2021 for this driver to push inflation significantly above 2%.
- Energy prices fall: Alternatively, if energy prices drop back to pre-pandemic levels, inflation would tumble below 0% by the end of 2022.
What about wages or big-government social programs further boosting inflation? The eurozone backdrop differs from the United States in this regard. In Europe, furlough programs preserved jobs and maintained wages during the downturn, but also kept wages from surging as the economy reopened. The eurozone economy has slack to grow without causing excess inflation.
Inflation fears may be peaking, along with concerns that the ECB may stall the recovery by acting too quickly to raise rates. Moreover, we don’t expect quantitative easing (QE) to end in 2022. As the Pandemic Emergency Purchase Program concludes in March, it leaves the pre-pandemic Asset Purchase Program to continue to support financial conditions. The combination of ongoing monetary and fiscal stimulus should support above-average growth in 2022.
Fixed Income: The bond market has a message for the Fed
The dominant trend in the Treasury market over the past few months has been the flattening of the yield curve—a narrowing in the difference between short- and long-term yields. Short-term interest rates continue to move higher on expectations that the Federal Reserve will be raising the federal funds rate target, but longer-term yields have failed to rise significantly. Consequently, while yields for most maturities are higher than at the start of the year, the slope of the yield curve is much flatter. The spread between two and 10-year Treasury yields has declined from about 120 basis points2 to 78 basis points in the past few months, almost entirely due to rising short-term rates. The yield curve usually flattens in a tightening cycle, but it is notable that it’s happening against a backdrop of the highest inflation readings in decades, and steeply negative real interest rates and the Fed’s decision to taper its bond purchases.
The Treasury yield curve has flattened since the September FOMC meeting
Source: Bloomberg, data as of 9/22/2021 and 12/13/2021. “FOMC” refers to the Federal Open Market Committee, which meets multiple times each year to determine Federal Reserve monetary policy. Past performance is no guarantee of future results.
There are several potential explanations for the trend in yields. Each is sending a signal about the implications for tighter Fed policy.
1. Investors are anticipating slower growth and lower inflation under tighter Fed policy. As the Fed pulls back on its very easy monetary policy of the past two years, markets appear to be building in a reversion to the long-term trend of slow growth and low inflation that prevailed before the onset of the pandemic. The trend suggests investors are concerned that the Fed could make a policy mistake by tightening too fast or too soon.
The recent dip in inflation expectations supports this point of view. After peaking in early October, the expected inflation rate embedded in the pricing of Treasuries (5 year/5 year forward rate) has fallen back to about 2.2%, consistent with the Fed’s long-term target.
Inflation expectations have fallen
Notes: The 5Y5Y Forward Inflation Expectation Rate is a measure of the average expected inflation over the five-year period that begins five years from the date data are reported. The rates are comprised of Generic United States Breakeven forward rates: nominal forward 5 years minus US inflation-linked bonds forward 5 years.
Source: Bloomberg 5-year 5-year Forward Inflation Expectation Rate (USGG5Y5Y Index). Daily data as of 12/13/2021.
2. Fed bond buying is still supportive to the market and higher rates are delayed. The alternative interpretation is that since the Fed just began to reduce the pace of its bond buying, the impact on intermediate to long-term yields has yet to be seen. Although the Fed has begun to taper its bond purchases, it still holds a substantial proportion of intermediate to long-term Treasuries and mortgage-backed securities. Overall, the Fed holds about 25% of outstanding Treasury debt. If this is the case, then the pace of Fed tapering should have a significant impact on yields. This theory should be tested as the Fed pares back its purchases at a faster rate in the months ahead. Based on an expected reduction of $30 billion per month in purchases compared to the current pace of $15 billion, the Fed should end its bond-buying program by the end of the first quarter of 2022.
Source: Bloomberg. Federal Reserve Balance Sheet Securities Held Outright: Treasuries & Mortgage-Backed Securities (FARWUST Index, FARWMBS Index). Monthly data as of 10/29/2021.
While this explanation is logical, in previous periods when the Fed ended its bond buying programs, 10-year Treasury yields declined. Moreover, there is no consensus among economists about the impact of bond purchases. Estimates for the impact on 10-year yields range from 50 to 150 basis points from peak levels.
Since markets are supposed to be forward-looking, it may be that the tightening signal from the Fed when it plans to end its bond buying has a bigger impact on the market than the actual purchases. Nonetheless, the market seems to be indicating that the Fed can go ahead with faster tapering without sending yields significantly higher and curtailing the expansion.
3. Long-term prospects for higher bond yields in developed-market countries are limited. A third interpretation of the flattening yield curve is that markets see limited upside potential for long-term yields. With global populations aging and savings rates high, strong demand for long term bonds is keeping a cap on yields. Insurance companies and pension funds continue to increase their purchases of long-term U.S. debt to meet long-term liabilities, even as yields fall because U.S. yields are still higher than those in most other major countries. Meanwhile, the U.S. is likely to lead to a decline in issuance of U.S. Treasury debt compared to a year ago as the economy recovers, which should take some of the upward pressure off of yields.
Overall, the message from the yield curve seems to be that the Fed may not have as much scope to raise short-term rates as its forecasts suggest. Throughout the past few years, the Fed’s economic projections have indicated that it sees the longer-run fed funds rate, the “terminal rate,” at 2.5%. However, the implied market forecast has been consistently lower. Over time, these estimates are likely to converge, but it is likely to be the result of the Fed’s estimate declining rather than the market estimate rising.
The Fed vs the market
Note: The 12/15/2027 Eurodollar futures rate was used for the Longer-Run market rate.
Source: Bloomberg. Fed estimate as of 9/22/2021. The market estimate of the federal funds rate using Eurodollar futures (EDSF). As of 12/13/2021.
Washington: Debt ceiling pressure is off
Congress this week passed legislation that lifts the debt ceiling by $2.5 trillion—enough to take the issue off the table until early 2023. This provides some much-desired certainty to the markets, which historically have become very volatile as a potential U.S. debt default approached. This week’s votes bring to an end the latest iteration of this drama, which persisted through the fall as Democrats and Republicans engaged in a standoff about how to raise the debt ceiling. Neither party wants to be talking about this issue next year during the midterm elections, so the agreement raised the limit by enough so that it won’t have to be dealt with well after the election.
Meanwhile, prospects for the Senate resolving the Build Back Better Act before the holidays continue to dim. Senate Majority Leader Charles Schumer (D-NY) keeps saying that the Senate will vote before the holiday break on the roughly $2 trillion legislation that focuses on climate change and social programs. But that is looking increasingly unlikely as Senate Democrats are struggling to resolve a number of sticky issues. Senator Joe Manchin (D-WV), the moderate who has been expressing concerns about the size and scope of the bill for months, has said he is frustrated that the bill does nothing to address the rising debt and has also said that it may not be appropriate to pass such a large bill in the face of rapidly rising inflation. While Manchin has avoided specifically saying that he wants the bill delayed until early 2022, he is certainly sending signals in that direction.
Senate Democrats are also struggling to come to an agreement on the state and local tax (SALT) deduction. The Senate Finance Committee recently released its version of the tax proposals in the House-passed Build Back Better Act. For the most part, there were few major changes, just some technical tweaks and fixes to certain aspects of the House provisions. There was one notable exception: The Senate version contains a blank placeholder for the state and local tax deduction. The House bill increases the cap on the deduction from $10,000 to $80,000. But numerous Senate Democrats have balked at the size of the increase. Various attempts at a compromise have been floated, including a lower cap or an income limit on who can take advantage of the higher cap, but no deal has been reached yet. Internal negotiations are expected to continue this month.
1 The Conference Board, “Consumer Confidence Declined in November,” November 30, 2021.
2 One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.
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