Drivers of Higher Rates: Good and Bad Inflation

[Apologies to subscribers: Friday’s post was sent prematurely and did not have a link. Hopefully the link and edited version is sent successfully Saturday.]

The 5-year Treasury yield hit 2% this morning. It’s not much, but the short to middle of the curve is starting to look a little more interesting (relatively). As I wrote in “Patience – A Possible Win Win”, I believe “…as long as financial conditions remain stable and equity prices inflated, the Fed will most likely continue raising rates. In effect, until something in the financial markets ‘breaks’, the Fed’s tightening path appears to be on a set course.”

In other words, as the asset inflation fires rage in risk markets, the Fed has cover to raise rates. And who knows, they may actually feel responsible enough for their asset inflation inferno, and its potential risk to the economy, to at least begin building some fire lines.

While I believe rising asset prices have contributed to the recent increase in interest rates, I’m also continuing to detect signs of less investor-friendly forms of inflation. As I documented in past posts with examples, costs and wages are rising for many of the businesses I follow. While I prefer viewing inflation from a bottom-up perspective, my observations have recently been confirmed by unlikely top-down sources — the media and the Federal Reserve.

Below are a few headlines I noticed this week while watching Bloomberg TV and reading the financial news.

“Consumer Price Index Jumps 0.5% in September”

“Canada Annual Inflation Rises in September on Gasoline, Food costs”

“UK Inflation Hits 3% in September”

“Commodities Rally a Welcome Tailwind for Asia Open”

“China’s Factory Inflation Rebounded”

“New Zealand Inflation Quickens More Than Economists Forecast”

Even the Federal Reserve is beginning to take note of rising costs, or specifically, the tightening labor market (thanks to a reader and very knowledgeable investor for pointing this out).

Similar to the information I accumulate each quarter from small cap businesses, the Fed’s Beige Book gathers and summarizes economic information by interviewing “business contacts, economists, market experts, and other sources.” Below are the Fed’s comments on labor, which conform with many of the company-specific results and commentary I’ve recently discussed.

“Labor markets were widely described as tight. Many Districts noted that employers were having difficulty finding qualified workers, particularly in construction, transportation, skilled manufacturing, and some health care and service positions. These shortages were also restraining business growth.”

“Despite widespread labor tightness, the majority of Districts reported only modest to moderate wage pressures. However, some Districts reported stronger wage pressures in certain sectors, including transportation and construction. Growing use of sign-on bonuses, overtime, and other nonwage efforts to attract and retain workers were also reported.” [my emphasis]

Interesting, isn’t it? Consumer prices are up 2.2% year over year (over 2% goal), unemployment is near 4% (under full employment), and the Fed’s own Beige Book is reporting tightness in the labor markets, with shortages and the growing use of signing bonuses. Meanwhile, after a nine year bull market in risk assets and an economy displaying classic late-cycle signals, Fed policy remains in an emergency and very accommodating stance (negative real short-term rates and a severely bloated balance sheet). From a policy perspective, is it 2009 or 2017? Hard to say.

As I noted in a previous post, “Exactly when the current market cycle ends remains unclear, but in my opinion, the cozy relationship between short-term interest rates and equities is over. Going forward, higher stock prices will most likely lead to higher short-term rates.” And this is exactly what has happened. However, when I initially wrote this, I was focused mainly on asset inflation.

Going forward (barring a decline in asset prices), I suspect there will be a growing number of headlines related to other forms of inflation. In my opinion, given the widely-held belief that interest rates will stay low indefinitely, broadening inflation, from the perceived good to the bad, is something investors should monitor closely.

Sorry for the short post this week. As many of you can relate, I’m currently very busy plowing through earnings season. I’ll publish my own Beige Book in a couple weeks, summarizing the operating environment and economy through the eyes of business.

Have a great weekend…and I hope you’re enjoying these higher interest rates!