Published on June 11, 2021 in the Rochester Business Journal
For the third time in the last 80 years, we’re in the midst of a secular (i.e. long-term) bull market. Upward-trending markets like this tend to last fifteen to twenty years and are generally characterized by significant declines in unemployment, along with noticeable increases in inflation and interest rates. The idea is that as an economy emerges from recession – like the Great Recession of 2008 – economic activity picks up, people return to work, demand begins to outstrip supply, and prices begin to rise. Eventually, the Federal Reserve Bank (the Fed) finds it necessary to raise interest rates, usually several times, to slow things down a bit and to prevent more rampant inflation. Monitoring these three metrics – unemployment, inflation, and interest rates – can tell us a lot about where we are in a longer, broader market cycle, and the COVID-19 pandemic has had a noticeable impact on all three.
As recently as February 2020 and right at the onset of the pandemic, unemployment had fallen to 3.5% - its lowest level since 1969, when it dropped to 3.4%. The lowest rate of unemployment ever recorded was 1.2% in 1944, and the Federal Reserve Bank considers the natural rate of unemployment to be between 3.5% and 4.5%. In essence, unemployment was right about where we might have expected it to be by February 2020, after nearly eleven years of a secular bull market run, but then along came COVID. In just two short months, unemployment increased from 3.5% to 14.8%, effectively introducing a cyclical (i.e. short-term) bear market to our secular bull market, and hitting the rewind button on our position in the latter. Fortunately, the recession spawned from the pandemic was one of the shortest on record and, since April of 2020, the unemployment rate has mostly trended down to its current rate of 6.1% - lower than the pandemic high of 14.8%, but still a far cry from the pre-pandemic rate of 3.5%.
Since 1914 and according to InflationData.com, average annual inflation, as measured by the Consumer Price Index – All Urban Consumers (CPI-U), and as compiled by the U.S. Bureau of Labor Statistics, has varied from negative 10.3% in 1932 (i.e. deflation) to 17.8% in 1917. In any given year over that 106-year period, inflation exceeded 10% a total of nine times and has only been negative by more than 10% once. Although the Fed now targets an average annual rate of inflation of 2%, we’ve only seen it exceed that level four times since the end of 2008 and certainly not by much. In fact, inflation averaged 1.81% and 1.24% in 2019 and 2020, respectively, and only 1.55% over the twelve-year period ending 12/31/20. However, based on some relevant data, that may be about to change.
When an investor considers how a 10-year, U.S. Treasury Note is priced relative to a 10-year, Inflation-Protected Treasury Note – also known as a Treasury Inflation-Protected security or TIP, there is an implied breakeven rate of inflation that reflects the market’s expectation for inflation over the ensuing ten-year period. Recently, it appears that this expectation has been on the rise. In March of 2020, as COVID permeated all walks of life, the 10-year TIPs breakeven rate was only 0.5%, but it has since risen to 2.41%. In short, inflation has room to run, the Federal Reserve seems more willing to let it run, and the market is expecting it to do just that, based on the way current TIPs are priced. How high inflation will go is anyone’s guess, but pent-up demand from the COVID pandemic and a low interest rate environment has already caused big price movements in commodities like lumber, corn, gasoline, and copper, just to name a few (front-month futures contracts are up 278%, 108%, 96%, and 86%, respectively, as of 5/18/21). To boot, ongoing quantitative easing – essentially the printing of more dollars – is only serving to exacerbate underlying inflationary pressure.
The Federal Reserve Bank controls the Federal Funds rate - a measure of interest that other rates are benchmarked to - in an effort to fulfill its dual mandate of promoting full employment while, at the same time, controlling inflation. It now quotes the Fed Funds rate in terms of a targeted range, which is currently 0 to 0.25%. The Fed raised rates nine times following the Great Recession, but was forced to cut them to their current level due to the pandemic. The last full cycle of Fed Fund rate hikes took place between June 2004 and June 2006, when the Federal Reserve Bank increased rates from 1% to 5.25%. The Fed Funds rate had been as high as 2.5% prior to the pandemic and the Fed has pledged to hold rates near zero (i.e. no rate increases) until at least 2023.
Despite what the Fed has told us they’re going to do, the financial markets seem to be well ahead of reality and are already discounting the prospect for higher interest rates (i.e. U.S. Treasury Bond prices have been falling and U.S. Treasury Bond yields have been rising). From the beginning of 2021 through 5/21/21 alone, the yield on the 5-year Treasury note has increased by approximately half a percentage point to 0.84% and the yield on the 10 and 30-year Treasury securities have increased between a half and three-quarters of a percentage point to respective levels of 1.63% and 2.33%. Though rates are still low by historical standards, they appear to be on the move, with the propensity to move even higher. Some of this reflects the market’s expectation for higher inflation, but it’s also a reflection of the large deficits we’ve been running and the ever-increasing levels of debt we’ve been accumulating. As this debt, particularly debt as a percentage of GDP, continues to grow, we become a greater credit risk. This should ultimately contribute to higher rates as our creditors look to be compensated for this added risk.
In summary, unemployment is relatively high due to COVID, but trending lower. Inflation and interest rates are relatively low but are trending or are poised to trend higher – again, in large part due to COVID. Twelve years into a secular bull market that typically lasts fifteen to twenty, the longer-term expansion we’re experiencing could well continue another three to eight years. The five-year forward Treasury yield curve is currently flat, but not inverted, which is significant – inverted yield curves tend to destroy secular bull markets, as short-term rates begin to climb higher than long-term rates. Beyond the five years projected in today’s forward yield curve, the prospect for continued growth becomes a bit more uncertain but, for now, sit back and enjoy the ride.
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