10-Year Yields & Cyclicals, Worst Case US Inflation

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10-Year Yields & Cyclicals, Worst Case US Inflation

Two Data Items today:

#1: 10-year Treasury yields, which have started to show signs of life again. After going from 0.9 percent at the start of 2021 to 1.75 pct at the end of March, they pulled all the way back to 1.17 pct at the start of this month. At today’s close yields sit at 1.35 pct, very near their August highs (1.37 pct), and look to have some momentum going into Jackson Hole on Friday.

Now is a good time, therefore, to pull up what we like to call “the most important chart for 10-year Treasuries”, aka yields over the last decade. As the image below shows, 1.5 percent is a critical level. Prior to the Pandemic Recession, whenever yields reached 1.5 pct they rose. After 2020 when yields breached 1.5 percent, they quickly fell. Granted, the latter experience only has one observation, but it does line up exactly with the old support line for yields. It’s the classic “support becomes resistance” idea popular in technical trading circles.

More important to how US stocks trade is the following chart: 10-year Treasury note yields minus 3-month bill yields. This is the data the NY Fed uses in its popular Recession Probabilities indicator. When the 10-year/3-month spread goes negative, recession looms. When it is increasing in value, recession is less likely. For a brute-force tool, it is remarkably prescient, as the chart below from 1982 – present shows.

We’ve highlighted the March 2021 reading on the far right because it coincides with peak investor enthusiasm regarding post-pandemic economic reopening. The Russell 2000 topped out in March. Most of the YTD returns in US large cap Financials and Industrials occurred between year-end 2020 and March as well. The same goes for oil prices and large cap Energy stocks. The spread’s decline since then didn’t ring any recessionary alarm bells for all the obvious reasons, but it did cool the “reopening trade” so much in evidence during Q1.

Takeaway: while we’re certainly not in the “taper tantrum” camp (reduced Fed bond buying will have a significant effect on 10-year yields), it is reasonable to think 1.5 percent will once again be a floor for yields once tapering is announced. We’re not that far away right now. In that event – which is our base case – cyclical stocks should outperform, as they did in Q1. We continue to like (in order): Energy, Financials, and Industrials.

#2: How bad can US CPI inflation get in 2022? To consider that question, we did something like the “value at risk” calculation used by portfolio managers, which looks back across the last 100 days (or thereabouts) and takes the most adverse price for everything in the portfolio. Apply all those prices to the current pad, and you have a theoretical “worst case scenario” for the portfolio.

Since inflation ebbs and flows across the business cycle, we looked back 10 years and identified pre-pandemic “peak inflation” for every important segment of the US Consumer Price Index. Here are those categories, their current CPI weightings, their peak 2010s cycle year-on-year inflation readings, and when those occurred:

  • Food (13.9 pct of CPI): +4.5 pct (September 2011)
  • Energy (7.2 pct): +19.0 pct (July 2011)
  • Commodities less food and energy commodities (20.7 pct): 2.2 pct (November 2011)

    Note: this includes items like apparel, new and used vehicles, alcohol, and tobacco.
  • Shelter (32.6 pct): 3.6 pct (December 2016)
  • Medical Care Services (7.1 pct): 5.1 pct (August 2016)
  • Transportation Services (5.3 pct): 4.5 pct (February 2018)

The result of this “worst case scenario”, based on the highest readings for annual inflation across every major CPI category at any point from mid-2011 to 2020, is 4.2 percent headline inflation. This, we would note, is still less than July 2021’s 5.3 percent CPI reading. Put another way, if the proverbial sun, moon, and stars align for all these segments, it still doesn’t reach current levels since these are so deeply affected by easy comps to last year.

Takeaway: while 4 percent US inflation in 2022 would certainly be a shock, this analysis shows it would require simultaneous price increases across a wide array of categories that do not typically peak at the same point in the cycle. As such, this scenario seems very unlikely. Now, if we get an oil shock, all bets are off – history is very clear on that point. But that’s also the reason we always say to at least equal-weight Energy stocks; this group is the only effective hedge if oil prices suddenly spike.