Inflate Or Die

1.) INFLATION – As you know, the Fed stood still last week and did not raise or cut rates. Fed Chair Warsh made it pretty clear that rate cuts are off the table, and if inflation refuses to cooperate, the next move is likely higher. So, traders pushed 2YR yields higher as they priced in another hike before year-end. On the surface, this looks like a hawkish central bank. But never forget Richard Russell’s famous line: “Inflate or die.” Debt-based economies need inflation. Governments owe too much money, and inflation quietly reduces the real burden of debt. Deflation does exactly the opposite, which is why the Fed can never accept a deflationary spiral and will always tolerate more inflation than investors think they will. That is until they can’t. Eventually, inflation becomes the larger threat. Confidence in the currency begins to matter more than supporting economic growth. That’s when central banks have no choice but to tighten financial conditions, even if it means slowing the economy. So the real question to ask is whether it’s reached the point where the Fed can no longer tolerate the rate of change of inflation. As investors, we care about where things are headed. Markets don’t move because of what central bankers say. They move because of where capital flows. Below is an important macro chart. On the top is XLE, the Energy Select Sector ETF. On the bottom is TLT, the 20+ Year Treasury Bond ETF. Earlier this year, while everybody was debating whether inflation had finally been defeated, energy stocks quietly broke out to new highs. Institutions were buying one of the most inflation-sensitive sectors in the market. Now, bonds are just breaking down as rates move higher. This is what it looks like during a structural inflationary environment. As investors demand higher yields to own long-duration bonds, bond prices fall. That’s exactly what we’re seeing in TLT. If investors truly believed inflation was headed back to 2%, long-duration Treasuries would likely be leading while energy struggled. And now bond volatility (MOVE Index) broke above 80. Rising bond volatility is always a potential problem. The bottom line is that the market is still signaling that inflation is an issue. Now, interestingly, and perhaps paradoxically to some, could the bond market start to pull in demand with the current higher yields? Yes.

2.) TAYLOR RULE – I don’t want to get “academic,” but the Taylor Rule is a monetary-policy guideline proposed by economist John B. Taylor that recommends how a central bank should set its short-term interest rate in response to deviations of inflation from its target. The Fed pays attention to it, and Fed Chair Warsh spent a lot of time with Taylor at Stanford. What is it saying right now? It suggests that the current level of interest rates is way too low. This supports what the bond market is saying, as pointed out above.

3.) 30-YR YIELD – Why are long rates at the highest level in 20 years? 1) Inflation, 2) Fiscal problems, 3) Hyperscaler issuance. The bottom line is that we're not likely going back to the 2010s, and as suggested in point 1 this morning, that could be good news for bond market demand. What’s the cure for high rates? High rates.