The Biggest Question You’ve Asked This Year

July 2021 | Victoria Bogner, CFP®, CFA, AIF®

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Throughout 2021, we’ve seen the US economy transition from lockdown mode to the floodgates of demand bursting open. Vaccinations became available to any adult who wanted one, and the masks I paid $5 for are now on clearance for 25 cents. All good news, right? With the economy opening and the gears greased by high demand and even higher liquidity, many of my clients have been asking my thoughts on one thing in particular: inflation. While stocks continue to rise for the most part, 2021 has seen Treasuries off to one of their worst starts in years with the 10-year Treasury bond down over 4% in the first quarter. The main culprit? Rising yields triggered by the fear of inflation. 

Such a speedy recovery from the pandemic has created pockets of disruptions, some of which you may have personally experienced. My husband, who works as an electrical design engineer, is acutely aware of the global chip shortage affecting the consumer products he designs. The trickle-down is having a huge effect on vehicles with a shortage in new cars. Rental car shortages are something we experienced on our recent vacation. Flights and lodging were relatively cheap. Our rental car, however, cost more than both of those aforementioned items combined. We were lucky to find one at all. Then there are building material shortages for those trying to build homes or renovate. And with oil prices on the rise, consumer staples could become more expensive as well. 

Inflation in and of itself isn’t a horrible thing. A slow, steady rise in prices over time is healthy for a consumer-based economy like ours. But too much too soon can wreak havoc. Ironically, for stock investors and bond investors in particular, the main fear isn’t inflation itself as much as what the Federal Reserve would do to counteract it: raise the federal funds rate, which could ultimately put pressure on financial markets. 

When rates move higher, bond prices go lower. It’s an inverse relationship that we’ve seen play out so far this year. As the economy recovered from the pandemic-induced shutdown, a little inflation was expected; however, higher than expected demand, record low supply, and trillions of dollars sloshing around in stimulus mixed together to create some inflation numbers that were higher than what anyone expected. The monthly changes from the prior year are 4-5% each month for the past 3 months. 

Does this mean the Federal Reserve is going to raise rates anytime soon? Are those fears founded? A few months ago, the Fed was firmly in the position that inflation would be temporary but as demand and supply evened out, it would go back down toward their target. In the most recent June meeting, they took a much humbler tone. The Fed now acknowledges the upside inflation risks and Chairman Powell said they have started to talk about an eventual tapering of asset purchases. Instead of waiting through the end of 2023 to begin raising rates, it could happen as soon as the end of 2022. While it spooked the markets slightly, this week’s meeting was an important step. We don’t want the Fed to be blind to the uptick in inflation and the data that goes along with it. They did the right thing. They have to begin reminding investors that at some point in the future, asset purchases will stop and rates will go up. But I don’t envy them their job. Getting that timing right and doing it with a smooth glide path will be one gargantuan task. The Fed has created an exceptionally loose stance on monetary policy with some even insisting they went way too far. Now if we see the economy continuing to generate high GDP and inflation ticking ever upward, that loose policy will be out of lockstep with the fundamentals. In my opinion, the best thing they could do would be to set expectations early, often, and begin the tightening process sooner and slower. But they didn’t ask me. 

Meanwhile, even as 10-year US Treasury rates have moved higher on the Fed’s news, the challenge for conservative investors remains how to generate yield without being forced further and further out on the risk limb. Some ideas to consider are inflation protected bonds, which will theoretically experience some insulation from high inflation. Bonds with shorter time frames (aka low duration bonds) are less affected by rate moves than long-term bonds. And as long as you do your research, you could venture down into the BB-rated space if you’re willing to take a bit more risk. Of course, everyone’s situation is different so if you’d like advice specifically for you, give us a call and we’re happy to help.

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