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Core Comments Quarterly Newsletter, 3rd Quarter, 2022

During the third quarter most markets continued their decline. Yet there were exceptions like Bitcoin that was essentially flat after losing 57% in the second quarter. Another exception was the dollar which rose 8.6% in the quarter. This contributed to the decline in the British Pound which hit an all-time low. Their bond and equity markets also were hard hit but much of this was obscured by the Queen’s passing. The best pieces of news included the Covid vaccine becoming an annual event in most of the world except China. Then the performance of the Ukrainian army’s retaking much of the land they lost in the early stages of the war was unexpected. It seems everyone overestimated the Russian army.

All the turmoil this year is the result of the Fed and more recently the central banks for the European Union, Japan, and the UK which have a moved to reduce inflationary outbreak. They all have and are employing the same tool, raising interest rates. Rate increases cause the economy to slow which in turn slows inflation but at the cost of eventually putting people out of work and causing some businesses to fail. Unfortunately, no one has found a way to reduce inflation without this ultimate collateral damage and the developed world is pursuing it on a coordinated basis.

In the US we have had five increases taking the rate from zero to 3%. The futures market for the Fed Funds rate is currently predicting the rate will reach 4.4% by year end and we have two meetings of the Federal Reserve board remaining this year, so they have the opportunity. When you think about it 3% or even 4.4% doesn’t seem to be that high a rate to cause all the losses we have seen in both bonds and equities. It is not the absolute level but the speed of the increases and the maturity of the bonds in existence that are responsible for the damage. I will explain.

The Federal reserve normally is not in a hurry, typically it moves in 0.25% increments, appearing to be in control and deliberative. So far this year they have moved by 0.75% on three occasions which sends market participants the message that inflation is much worse than it had been portrayed so some overreaction should be expected. During 2021, the Fed said the inflation would be transitory, that year Inflation came in at 1.4% and ended the year at 7% in December while the Fed held the Fed Funds at zero. This continued until March 2022 when they raised the rate 0.25% and inflation hit 8.5%. Then the fire drill really begins with a 0.5% increase in May and the first 0.75% increase in June when inflation peaked at 9.1%. In those four months the messaging from the Fed changed, dropping the transitory view, and switching to “we will do what it takes to bring inflation back to 2%”, but they were too late.

This situation is politely referred to as a “policy error” but in other terms the Fed “painted itself into a corner” or “fell behind the curve”, by allowing inflation to get to an uncomfortable place. The Fed started with a goal of raising inflation to 2% after a decade in which inflation was below that level, but their efforts ended up overshooting their target by 7%, (i.e. 9.1% vs the 2% ideal). At least the inflation rate has begun to decline reaching 8.3% in August. Hopefully that continues.

Fed Funds are an overnight loan between banks, yes that is 24 hours, the ultimate short-term loan. Bonds or loans of more than 24 hours are more sensitive to changes in interest rates, the longer the time to maturity. It’s easy to understand that longer term bonds have more exposure to inflation risk, so their prices drop swiftly when rates rise and by magnitudes that most people do not think possible.

Most people retain the idea that bonds are suitable for widows and orphans. That idea went out the window in the 70s and 80s, but the lessons of that era have been forgotten after thirty years of steadily declining interest and inflation rates. So, a seemingly small 3% increase in the Fed Funds rate caused the US Aggregate Index (an index comprised of Investment grade US bonds, but the biggest portion is US Treasury bonds as they are the largest borrower in the US) to drop 14.6% so far this year. The loss is not due to declining credit quality or defaults, it is the result of the duration, a measure of the sensitivity of bonds to changes in interest rates.

Will interest rates continue to rise if inflation stays at say 8%? That is not likely since at some point the economy is likely go into a recession. Interest rate increases by themselves do not slow inflation. They do impose additional costs on business that eventually cause them to curtail their output as consumers slow down their buying in response to higher prices. That is the Fed’s plan now and it is the same plan Paul Volcker used in the 80s to reduce a much more severe inflation. They must follow this path, or the interest cost of the government’s debt will grow rapidly. The real question for the Fed and Treasury is how you pay the interest bill. The simplest solution is to prevent it from increasing by forcing inflation back to the 2% level which implies a recession in our future.

Inflation is also hard on consumers especially those on a fixed income. The current burst has been difficult as consumers never seem to be able to keep up with inflation. This is a time where having some duration risk is attractive because a recession will bring lower interest rates reversing the losses. Professional fixed income investors are all talking about taking more duration risk. This is a time where you do not want to fight the Fed.

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