Congress Passed Stimulus. Now We're on Our Own

This week Congress finally passed a long-awaited Covid-19 relief package. Looking back over the pandemic, markets have routinely been driven by hopes for external support, either from the Fed or from Congress. The passage of this deal probably marks the last time stimulus will be at the forefront of investors' minds. We are going into 2021 on our own. Here are my thoughts on 2021 for interest rates, the Fed and the economy. We're on Our Own. For Real. The dust hasn't yet settled on the latest Covid-19 relief deal in Congress and already some are talking about another stimulus package. Barring a major setback with the vaccine, however, I think we've seen the last of major stimulus deals. It is possible that incoming President Joe Biden manages to negotiate an infrastructure program, which could be large and could have a significant long-term economic impact. But such a program won't have the immediate economic jolt that sending out checks had. The era of Congressional negotiations driving markets is probably over for a while. I feel similarly about the Fed. The good news is that the Fed will keep short-term interest rates extremely low, even as the economy improves, which has the potential to make this recovery much more robust than the prior two recessions. But that's about the extent of what the Fed can (or will) do to juice the economy. Commentators will probably keep playing up the possibility of an expanded quantitative easing program or perhaps even yield curve control. None of these will actually happen, though. The Fed just doesn't believe QE is an effective stimulus tool, and will probably only use it if a liquidity problem arises. Yield curve control was an idea the Fed favored when it was worried that short-term interest rates wouldn't respond quickly to rate cuts. Given the two-year Treasury is at 12 basic points, that's no longer a concern. No matter what you hear, more QE or yield-curve control is off the table for now. So this leaves us investors on our own. If earnings decline there won't be any commensurate decline in interest rates to goose multiples. If credit performance falters, there won't be any new Fed buying program to backstop spreads. Unless there's a liquidity problem or unless there's a catastrophic decline in economic activity, I think both the Fed and Congress are on the sidelines for a while. It's All About Inflation The Fed can't provide more stimulus, and it isn't going to start tightening policy until inflation accelerates above 2% for some period of time. We are a long way from 2%. On Wednesday the Bureau of Economic Analysis said that the core personal consumption expenditures inflation measure, which is what the Fed officially targets, came in at 1.38% year-over-year. Hence, it makes sense that, according to the most recent projections, most FOMC members think the target rate will still be at zero in 2023. This means that longer-term bond yields are going to trade on longer-term expectations. How long does it take for inflation to get to 2%? How long will it remain there? How high will fed funds have to go to tame inflation once it rises? These are the questions traders are trying to answer as they try to price longer-term bonds. Right now I'd say rates traders are in show me mode. The consensus is that inflation will rebound some in 2021, but that inflation never gets high enough to actually get a sustained rate-hiking cycle. We can see this by looking at a few different indicators. On the inflation side, TIPS break-evens have been rising steadily the last couple months. The 10-year has risen from about 1.70% in October to about 1.95% now. However, what's important is that the whole TIPS curve has converged at 1.95%. In June there was a 20 basis point to 30bps difference between 5-year and 10-year break-evens. This means that markets thought that inflation would be lower near-term, but accelerate longer term. Now markets are saying that inflation will settle in a bit below 2% and remain about there. Note that TIPS are based on the headline CPI inflation measure, which tends to be a bit higher than Core PCE. Yields Are 'Real' Low Moreover, note that real interest rates, that is rates less expected inflation, haven't been moving higher. Again, we can use the Treasury Inflation-Protected Security market to ascertain this. The 10-year Treasury yield has risen from 0.68% to 0.95% as I write this Wednesday morning. The stated yield on a 10-year TIPS, however, has actually declined slightly over the same period, from -0.95% to -1.01%. This basically says that traders don't think the Fed will have to hike rates to contain inflation. If they did, we'd see both traditional Treasury and TIPS yields rising. Because only traditional Treasury rates are higher, the market is saying that inflation will get close to 2%, but not rise meaningfully higher. It is also saying that if the Fed ever hikes, it will be only slightly and/or only for a short period of time. Real Yields, Inflation Expectations Can Still Rise I project that 2021 will bring a rethink on inflation. In the aftermath of 2008 and the extraordinary monetary policy that ensued, many traders went broke trying to bet on an eventual explosion in inflation. Now the pendulum has swung too far the other way. While it would clearly be a stretch to say the Fed will be hiking in 2021, or even in 2022, this is no reason to get myopic. If significant inflation pressures show themselves in the new year, it opens up some new possibilities. What if inflation does rise above 2.5%? What if the Fed has to hike several times to get inflation back under control? In the aftermath of 2008 and the extraordinary monetary policy that ensued, many traders went broke trying to bet on an eventual explosion in inflation. Now the pendulum has swung too far the other way. Right now these aren't even priced into markets as possibilities, at all. So if traders even start to contemplate these kinds of scenarios, interest rates will have to price higher. I expect by the second half of 2021, there will be signs of higher inflation, and this will change the narrative significantly. The Fed will stay resolute on keeping their target rates low, but this will only fuel concern that inflation could be permanently higher. The 10-year Treasury will probably move above 1.50% and toward 2% in this scenario. Where Does This Leave Stocks and Credit? The good news is that my outlook is a very positive one for economic fundamentals. Historically, it has been very rare for a major sell-off to occur in risk assets without some deterioration in the economic outlook. So broadly I think this is a constructive outlook for stocks and credit spreads. Valuations make this statement tricky, though. Higher interest rates could be a pin that pricks the bubble of some of the highest flying stocks. For junk bonds, valuations can't reasonably get better, but defaults should peak in the first half of 2021 and subside from there. That should mean that junk bonds can return about their yield, paltry as that may be.

Congress Passed Stimulus. Now We're on Our Own

Here's my take on the what to expect into 2021 for rates, the Fed, inflation and the economy overall.

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