An Eventful Q1 and a Wild Ride Ahead

The first quarter provided more volatility than many market participants have seen in their careers. The Fed had everyone guessing on the future path of policy rates and for good reason, as the inflation data and the Russia-Ukraine War caused volatility and confusion in the markets.

From a US economic perspective, inflation has been the top story. Over a trillion dollars of spending from the US consumer has shifted to goods vs. services since the outset of COVID-19. This has put extraordinary stress on global manufacturing and on the global supply chain. Capacity utilization (a measure of output at the manufacturer) has dropped, while time for delivery has increased. We are all very familiar with the response “that’s on back-order.”
Adding to the strain, the household savings rate spiked higher during the 2020 lockdown but has now dropped – this savings is clearly being spent. The US personal savings rate spiked to almost 35% of income in 2020, but has since declined to currently approximate the historical average of 6.4% (see Figure 1).

Thus we have historic levels of inflation as YOLO spending prevails. The headline Consumer Price Index (CPI) reached almost 8% in its latest year over year reading. CPI less food and energy was at 6.4% year over year (see Figure 2). These are the highest levels of inflation we have seen since the early 1980s. Many think the base effect of high prints in 2021 will fall out of the year over year reading and be replaced by lower levels in 2022, thus a lower inflation trend would emerge. This does not yet appear to be the case, and the Fed is now grappling with being way behind on taming inflation.

The Russia-Ukraine War weighs heavily on the global economy. The devastation we are seeing is a stark reminder of how pointless wars are. We hope a cease-fire and peace can be reached in the near term. Regardless of the timing of the end of the conflict, the sanctions on Russia will have a substantial effect on the lives of millions. Sanctions are easy to enact but not easy to unwind. Even if all Russian forces withdrew today and rebuilding efforts commenced at once, it is hard to tell how long it might take to resolve the dislocation in economic activity that has taken place.

The war also continues to exacerbate issues with the global supply chain. One market expert estimates Ukraine that is responsible for 15% of the world’s wheat harvest. Russian crude is 12% of the total global supply, Russian gas is 8%, and Russian coal is 16%. If Western Europe wants to wean itself off of Russian energy dependence, it will take years to rebalance. It’s possible we’ll see elevated energy prices for years to come.

Bond prices in Europe are reflecting some of the higher energy costs and overall higher inflation pressure. Negative-yielding bonds are also turning into a thing of the past. The ECB is considering rate hikes as its mandate to maintain price stability is brought into focus. A year ago, there were more than $17.5 trillion of negative-yielding bonds globally; now there are just under $2.5 trillion (see Figure 3). At the time of this writing, current market pricing has the ECB policy rate just above 0.00% by the end of the year.

An important question remains: How fast is this central bank hiking cycle? As policy rates rise and global growth slows, will we fall into a recession? How quickly and for how long will central banks be able to keep policy rates high before they are back to easing again? The Fed’s statement of economic projections (see Figure 4) has policy rates at the end of 2023 and 2024 higher (2.8%) than their longer-term neutral rate expectations (2.4%). Fed officials believe they will have to raise rates to slow inflation and then ease rates as demand destruction takes effect and the economy slows. The US Treasury (UST) yield curve is telling us that: 10-year UST yields minus 2-year yields, at the time of this writing, had turned negative. 30-year minus 5-year is also at historic lows. So, in essence, the Fed will be raising rates quickly, knowing they will need to ease rates quickly. This sounds like the 2017-2019 cycle all over again.