longcast
Well-Known Angler
//
CPI report
The January Consumer Price Index (CPI) report delivered a surprise jolt, accelerating to 3% year-over-year, exceeding economists’ forecasts and raising concerns about the Federal Reserve’s fight against inflation. This uptick, from 2.9% in December, was driven by a surge in food costs, particularly eggs, which saw a dramatic price increase. While seasonal adjustments and specific events like the Los Angeles wildfires may have contributed, the broader picture suggests persistent inflationary pressures, especially in core inflation, which also accelerated.
The data presents a challenge for the Federal Reserve. Despite Chair Powell’s statements emphasizing “great progress” in curbing inflation, the January CPI figures suggest the Fed’s work is far from over. The persistence of core inflation, coupled with a “supercore” measure excluding food, energy, and housing remaining elevated, casts doubt on the trajectory of disinflation. Even more concerning is the fading of core goods deflation, a key factor in previous inflation relief. This makes it harder for the Fed to justify potential rate cuts and increases the likelihood of rates remaining steady for a longer period.
Adding another layer of complexity is the potential impact of proposed tariffs. The January CPI report doesn’t yet reflect the possible inflationary effects of these tariffs, raising the specter of further price increases. This has significantly increased the risk of the Fed’s next move being a rate hike. The unexpectedly strong CPI data, combined with the potential tariff impact, paints a challenging picture for the Fed and suggests that taming inflation will be a more protracted and difficult process than previously anticipated.
Short-term versus long-term rates
As Jim mentioned in his note on Monday, the most important figure to the financial markets today is the 10-year US Treasury yield. Movements in the yield reflect expectations for inflation, economic growth, government fiscal responsibility efforts, productivity expectations, etc. Since the Fed’s initial rate cut in September, the 10-year US Treasury yield has increased by almost 1% while the FOMC-controlled Fed Funds rate has been cut by 1%. This is not typical. In fact, since 1966, there have been 11 easing cycles and only twice has the 10-year yield risen within the first four months of a rate cut.
The market yield on the 10-year US Treasury bond reflects investor expectations. A higher yield presents challenges on many fronts. The government may find that it is more costly to finance deficits and risky to concentrate its borrowing with short-dated maturities. Moreover, corporate borrowers will be forced to allocate larger portions of their cash flow to interest payments which will limit their ability to invest in expansion projects. Mortgage rates will be higher too, which will hurt consumer budgets.
We have lived through a 40-year period of declining 10-year US Treasury yields, albeit with plenty of volatility along the way. In 1980, the 10-year yield was 16%. The yield hit a low of 0.5% during the summer of 2020. This decline has acted like a tailwind for the economy by driving asset prices higher, which encouraged more spending and investments that grew economic activity in a self-reinforcing manner.
Since the lows of 2020, the yield on the 10-year bond has been trending higher and is now hovering around 4.6%. To his credit, Treasury Secretary Bessent has told reporters that the Trump administration is focused on the 10-year yield and not short-term rates controlled by the Fed. This statement was refreshing to hear. One of the biggest risks to today’s stock market would be a spike higher in long-term interest rates. The success or failure of the DOGE will be important to watch in this regard.
I question whether the DOGE can deliver a $1-2 trillion reduction in government spending. If GDP is $29 trillion, then such a cut would cause an immediate recession because it would reduce economic growth by 3-7% if we use simple math. Of course, if the government can continue to deliver the same level of goods/services as it did prior to the cuts, then there would be a productivity gain and the economic impact would be less negative. Nevertheless, the ultimate amount of savings from DOGE is likely to be much less. Even if the savings are less, there will be a real benefit from any improvement in fiscal responsibility because it will lower 10-year US Treasury yields. Investors will have more confidence that the U.S. debts/deficits can be sustained into the future without a major devaluation of the US dollar.
The U.S. dollar
There is a real fear among a growing cohort of investors that the U.S. is inescapably heading toward a moment when the world realizes the U.S. dollar is no longer the store of value it once was. Decades of fiscal deficits and growing debts have put our nation’s debt/GDP ratio at levels not seen since the end of WWII. Unlike then, the U.S. now has trillions of dollars in unfunded liabilities such as Social Security and Medicare. Some estimates place these liabilities in the hundreds of trillions of dollars which makes our $39 trillion in funded debt look small in comparison.
Some investors and economists fear that the U.S. will be forced to print massive amounts of money (i.e., debasement of the currency) to pay for these currently unfunded liabilities. Investing in gold, Bitcoin, and other forms of inflation hedges is based on this concern. In fact, gold and Bitcoin have both outperformed the stock market during the last three-year period rallying by 60% and 120%, respectively, as compared to the S&P 500 which has increased 36% over the same time frame. It is too early to know whether DOGE will be successful or where exactly the 10-yield US Treasury yield will be next month, or next year for that matter. But that doesn’t mean we shouldn’t be prepared.
Big picture
There are several approaches to insulate portfolios from the risk posed by inflation/currency devaluation. Investing in companies that have strong business models and customer loyalty attributes which enable pricing power is a good starting point. Likewise, investors can avoid long-term fixed-income products because they do not compensate for rising prices and can cause a loss of purchasing power during periods of inflation.
For now, the economy remains strong with low unemployment of 4% and corporate profit growth projected in the 12-13% range for 2025. These figures support a stock market that is trading at 22x, which is near the high end of its historical valuation metrics. However, if yesterday’s CPI report surprise is repeated in the months ahead, things could get a little bit more turbulent.
Former Duke basketball coach Mike Krzyzewski turns 78 today, musician Peter Gabriel turns 75, and Senator Richard Blumenthal turns 79 today.
CPI report
The January Consumer Price Index (CPI) report delivered a surprise jolt, accelerating to 3% year-over-year, exceeding economists’ forecasts and raising concerns about the Federal Reserve’s fight against inflation. This uptick, from 2.9% in December, was driven by a surge in food costs, particularly eggs, which saw a dramatic price increase. While seasonal adjustments and specific events like the Los Angeles wildfires may have contributed, the broader picture suggests persistent inflationary pressures, especially in core inflation, which also accelerated.
The data presents a challenge for the Federal Reserve. Despite Chair Powell’s statements emphasizing “great progress” in curbing inflation, the January CPI figures suggest the Fed’s work is far from over. The persistence of core inflation, coupled with a “supercore” measure excluding food, energy, and housing remaining elevated, casts doubt on the trajectory of disinflation. Even more concerning is the fading of core goods deflation, a key factor in previous inflation relief. This makes it harder for the Fed to justify potential rate cuts and increases the likelihood of rates remaining steady for a longer period.
Adding another layer of complexity is the potential impact of proposed tariffs. The January CPI report doesn’t yet reflect the possible inflationary effects of these tariffs, raising the specter of further price increases. This has significantly increased the risk of the Fed’s next move being a rate hike. The unexpectedly strong CPI data, combined with the potential tariff impact, paints a challenging picture for the Fed and suggests that taming inflation will be a more protracted and difficult process than previously anticipated.
Short-term versus long-term rates
As Jim mentioned in his note on Monday, the most important figure to the financial markets today is the 10-year US Treasury yield. Movements in the yield reflect expectations for inflation, economic growth, government fiscal responsibility efforts, productivity expectations, etc. Since the Fed’s initial rate cut in September, the 10-year US Treasury yield has increased by almost 1% while the FOMC-controlled Fed Funds rate has been cut by 1%. This is not typical. In fact, since 1966, there have been 11 easing cycles and only twice has the 10-year yield risen within the first four months of a rate cut.
The market yield on the 10-year US Treasury bond reflects investor expectations. A higher yield presents challenges on many fronts. The government may find that it is more costly to finance deficits and risky to concentrate its borrowing with short-dated maturities. Moreover, corporate borrowers will be forced to allocate larger portions of their cash flow to interest payments which will limit their ability to invest in expansion projects. Mortgage rates will be higher too, which will hurt consumer budgets.
We have lived through a 40-year period of declining 10-year US Treasury yields, albeit with plenty of volatility along the way. In 1980, the 10-year yield was 16%. The yield hit a low of 0.5% during the summer of 2020. This decline has acted like a tailwind for the economy by driving asset prices higher, which encouraged more spending and investments that grew economic activity in a self-reinforcing manner.
Since the lows of 2020, the yield on the 10-year bond has been trending higher and is now hovering around 4.6%. To his credit, Treasury Secretary Bessent has told reporters that the Trump administration is focused on the 10-year yield and not short-term rates controlled by the Fed. This statement was refreshing to hear. One of the biggest risks to today’s stock market would be a spike higher in long-term interest rates. The success or failure of the DOGE will be important to watch in this regard.
I question whether the DOGE can deliver a $1-2 trillion reduction in government spending. If GDP is $29 trillion, then such a cut would cause an immediate recession because it would reduce economic growth by 3-7% if we use simple math. Of course, if the government can continue to deliver the same level of goods/services as it did prior to the cuts, then there would be a productivity gain and the economic impact would be less negative. Nevertheless, the ultimate amount of savings from DOGE is likely to be much less. Even if the savings are less, there will be a real benefit from any improvement in fiscal responsibility because it will lower 10-year US Treasury yields. Investors will have more confidence that the U.S. debts/deficits can be sustained into the future without a major devaluation of the US dollar.
The U.S. dollar
There is a real fear among a growing cohort of investors that the U.S. is inescapably heading toward a moment when the world realizes the U.S. dollar is no longer the store of value it once was. Decades of fiscal deficits and growing debts have put our nation’s debt/GDP ratio at levels not seen since the end of WWII. Unlike then, the U.S. now has trillions of dollars in unfunded liabilities such as Social Security and Medicare. Some estimates place these liabilities in the hundreds of trillions of dollars which makes our $39 trillion in funded debt look small in comparison.
Some investors and economists fear that the U.S. will be forced to print massive amounts of money (i.e., debasement of the currency) to pay for these currently unfunded liabilities. Investing in gold, Bitcoin, and other forms of inflation hedges is based on this concern. In fact, gold and Bitcoin have both outperformed the stock market during the last three-year period rallying by 60% and 120%, respectively, as compared to the S&P 500 which has increased 36% over the same time frame. It is too early to know whether DOGE will be successful or where exactly the 10-yield US Treasury yield will be next month, or next year for that matter. But that doesn’t mean we shouldn’t be prepared.
Big picture
There are several approaches to insulate portfolios from the risk posed by inflation/currency devaluation. Investing in companies that have strong business models and customer loyalty attributes which enable pricing power is a good starting point. Likewise, investors can avoid long-term fixed-income products because they do not compensate for rising prices and can cause a loss of purchasing power during periods of inflation.
For now, the economy remains strong with low unemployment of 4% and corporate profit growth projected in the 12-13% range for 2025. These figures support a stock market that is trading at 22x, which is near the high end of its historical valuation metrics. However, if yesterday’s CPI report surprise is repeated in the months ahead, things could get a little bit more turbulent.
Former Duke basketball coach Mike Krzyzewski turns 78 today, musician Peter Gabriel turns 75, and Senator Richard Blumenthal turns 79 today.
