Stagflation Warning Signs
Lately there seems to be no end of discussions around inflation. It’s all over the news, social media, and most importantly in plain sight when shopping or pumping gas. There are many theories about its cause and likely trajectory. Some believe that inflation has come about as a combination of supply-chain constraints (due to Covid shutdowns), coupled with pent-up demand (again due to Covid shutdowns). The thinking here is that these Supply & Demand impacts should be short lived, creating only temporary or “transitory” inflation.
Another school of thought is that the inflation we are seeing has been created by so much monetary & fiscal stimulus pumped into the economy, again the blame here falls to Covid. The main weapon used was Quantitative Easing, where the Federal Reserve bought up Treasuries & Bonds in the open market, thereby creating a flood of liquidity. At the same time, the government provided much needed support to impacted businesses through PPP forgivable loans, grants, and favorable disaster loans. They also provided enhanced unemployment benefits.
It doesn’t matter what you believe caused the current high inflation rate, it’s already here, and our concern should be how long will it remain elevated and what can be done to reduce it. The main tool used by the Fed to reduce inflation is increasing interest rates. They can also reverse their Quantitative Easing with Quantitative Tightening, which is selling back to the market the Treasuries & Bonds they have been acquiring. This selling or tightening process also effects market interest rates. With more sellers in the market the price of these Treasuries & Bonds should come down, which will increase the yield/coupon/interest rate on them.
One of the scariest propositions for the Fed is the possibility of Stagflation.
Stagflation:
“Persistent inflation combined with stagnant consumer demand and relatively high unemployment” (Merriam-Webster Dictionary)
“Stagflation is characterized by slow economic growth and relatively high unemployment (or economic stagnation) which is at the same time accompanied by rising prices (i.e., inflation). Stagflation can be alternatively defined as a period of inflation combined with a decline in the gross domestic product (GDP).” (Investopedia)
The prospect of Stagflation is so scary because the only mechanism the Fed has to fight inflation is to increase interest rates and employ Quantitative Tightening. In normal circumstances that would be fine, but if we are facing into a recession at the same time as the Fed is fighting inflation, the Feds action could spiral the economy into an even deeper recession.
Inverted Yield Curves & Recessions
So far it doesn’t look like we are headed into a recession. Employment is strong, in fact we have more available jobs than people willing to fill them, and GDP is still growing. GDP did take a massive historical drop when Covid first arrived, dropping 31% in Q2 2020, however it jumped right back up by 33% in Q3 2020. Each quarter since then GDP has ranged from 2.3% to 6.9%.
There are some warning signs flashing regarding a potential recession. The inverted yield curve typically precedes a recession, and we have seen it invert this week for the first time since 2019. An inverted yield curve refers to the 2-Year and the 10-Year Treasury Bonds, and when the 2-Year interest yield is higher than the 10-Year, the yield curve is inverted. Typically, you expect a longer dated Treasury Bond to yield a higher interest rate due to the opportunity cost of investing your money for 10-Years versus 2-Years. When the yield curve inverts, the 10-Year interest rate has dropped below the 2-Year due to high demand for the 10-Year. As more people buy the 10-Year, it drives down the yield/interest rate on it. This can be seen as a flight to safety by investors worried about a recession.
It’s important to note that an inverted yield curve is not the cause of a recession, merely an indicator of investor sentiment. Also worth noting, the recent yield curve inversion which happened on Tuesday March 29th only lasted mere minutes. Although it has hovered close to inversion since then, so it is worth watching. Since World War II every yield curve inversion has been followed by a recession in the following 6-18 months.
Cost of Debt
As the Fed and the market fight back inflation, the cost of borrowing has increased substantially. Interest rates have jumped anywhere from 50 basis points (0.5%) to 150 basis points (1.5%), depending on the loan product, term, etc. While this is a massive jump relative to the rates from a few months ago, we are still in a very low interest rate environment in absolute terms when viewed from an historical basis.
If you have debt maturing soon, or you have a floating variable rate loan, now could be an ideal time to secure a longer-term fixed rate. Unless you are of the view that inflation is purely transitory and will subside before year end, and that we will return to the ultra-low interest rates we have all become accustomed to.
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