Potentially Potential

The latest inflation numbers came in at 6.8% year-over-year (headline CPI). That’s the highest since the 1980s. What’s more, the Federal Reserve capitulated from its “transitory” position and has signaled an acceleration of taper and interest rate hikes.

Figure 1: US Inflation

Unfortunately, this is the scenario I did not want to see but have been writing about all year. Hotter than expected inflation has cornered the Fed into faster and more aggressive tightening. Historically, this is negative for the business cycle and risk assets.

Markets are supporting that interpretation. For example, while we might expect long-term rates to rise due to higher inflation, the 10-Year Treasury yield has actually fallen since October and is back below a 1.5% handle. That implies the market is sniffing out lower long-term economic growth ahead (despite the inflation).

Figure 2: 10-Year Treasury Yield

If this trend continues as the Fed hikes, we’d end up with a “bear flattening” of the yield curve. In other words, long-term yields fall, short-term yields rise, and the yield curve flattens.

Taken too far, whether by policy or sentiment, and we end up with an inverted yield curve. That matters because an inverted yield curve is a strong leading indicator for economic contractions and bear markets (thus the term bear flattening).

Figure 3: US Treasury Yield Curve

To be clear, fair, and not alarmist, I’m not predicting we’re heading into a recession (I don’t know when that happens). Realistically, I’m talking about a potential bear-flattening, that could potentially lead to an inversion of the yield curve. That’s hardly a precise prediction. And even if it does happen, there’s a long lead time for both rate hiking and inversions (with respect to contractions).

What I am saying is circumstances and conditions are changing. Just as the Fed’s easy monetary policies are behind us, so is the “easy money” that markets have gotten used to (where prices only go up). 2022 is looking to be a year of transition and one when vigilance will be especially important. We are watching carefully, waiting patiently, and will be responding accordingly as conditions change.

Entering the final weeks of 2021, I want to express my sincere gratitude and appreciation to all our clients, families, and friends of BCM. Thank you for your continued confidence and support and here’s to yet another successful year!

Happy Holidays, I wish you all the very best in 2022.

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Victor K. Lai, CFA