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Revisiting Inflation and Interest Rates

| June 22, 2018

In my February blog, I outlined a few explanations for the market correction that began earlier that month. At this point, we can continue that discussion by focusing on the two justifications for the market’s action that relate to inflation and interest rates.

It has been over four months since we began to see wage inflation in the economic data, so it would be reasonable to think that market watchers would be moving toward a consensus view on where inflation and rates are heading. This has not been the case. Updating and reviewing the current views shows that the split in opinion continues to be considerable.

While there are nuances and variations, there are, generally speaking, two different widely held views on inflation and interest rates. One way of illustrating the division is to consider the idea of the ‘neutral interest rate’. This is the theoretical rate that would produce neither expansionary nor contractionary economic effects. The Federal Reserve would like to raise rates (or, ‘normalize’ in Fed speak) until the economy is growing in a non-inflationary way and the neutral rate has been achieved. To do this, the Fed believes (based on its ‘dot plots’) that it will have to raise the Fed Funds to around 3.25%-3.50% before lowering it back to the long-term neutral rate of around 2.90%.

One set of investors – the more dovish group that were described in my February blog as supporters of ‘Narrative #2’ – thinks that the Fed is already fairly close to achieving the neutral interest rate and should therefore act conservatively. Believers in this view would argue that if the Fed Funds rate increases much further, the yield curve will invert and a recession will be the likely result. In their opinion, the recent tax cut has front-loaded economic growth so corporate earnings are already peaking and inflation is likely to stay contained. Uncertainties and economic contraction that may result from trade tariffs reinforce this idea. Their hope is that more reserved Fed policy will enable an extension of the current economic cycle.

The second group – those that were more hawkish in February – are (still) more hawkish. In an interview with CNBC on June 12th, legendary hedge fund manager Paul Tudor Jones echoed several points made by investors in this crowd. His belief in emerging inflation is so strong that he thinks the Fed should immediately raise the Fed Funds rate by 1.50%. Underlying this outlook is the idea that the economy is already strong, and the lingering easy monetary policies and tax cuts are just adding fuel to the economic fire. This hawkish group likely agrees with Jones’ assessment of the probable outcome: “This is going to end with a lot higher prices and forcing the Fed to shut it off.” So, higher inflation and higher interest rates leading to a Fed-induced conclusion to the business cycle.

These two views have starkly opposing investment implications: Positioning on bonds and duration, currencies and geography, monetary versus hard assets, and equity market capitalization would all be much different. Investors can subscribe to one view or the other, and invest accordingly. Alternatively, investors may pursue a diversified portfolio that seeks exposure to the true global set of risk-reward opportunities. Active, tactical investors may feel comfortable taking on more opinionated and concentrated investments, whereas long-term, strategic investors may be better served by the more diversified method. Either way, investors should consider their positioning with respect to inflation and interest rates in a conscious and purposeful way. The worst risks investors face are often those of which they are unaware.