There is upside pressure on inflation and inflation expectations from tariffs, dollar depreciation and growing disagreement on the FOMC about how much weight to put on rising inflation relative to slowing employment.
The risks are rising that we could see another “inflation mountain” emerge over the coming months, see chart below.
The chart below shows quoted bid-ask spreads for public investment grade credit as a function of bond-level spread volatility. Both on-the-run and off-the-run bonds see higher transaction costs as spreads move, but the increase is far more pronounced for off-the-run bonds. This helps to explain why volumes remain depressed even in volatile periods.
The bottom line is that liquidity in public and private credit is converging, and in some cases where private credit is included in ETFs, private credit may even be more liquid than some segments of public credit.
For more discussion see also here.
The yield on Italian long-term government debt could, by the end of this year, be lower than the yield on France’s government debt, see chart below.
When the Fed raises interest rates, the idea from the FOMC is for investors to take less risk and make it more attractive to move money into safer fixed income.
With this backdrop, the convergence in yield levels across debt and equity markets is remarkable, see chart below.
Not only is the yield level in fixed income higher than it has been for many years, but the S&P 500 forward earnings yield and similar implied yield levels in equities have been coming down, see chart below.
The bottom line is that fixed income remains more attractive than the implied yield levels in public equity markets at the moment.
Put differently, risk is mispriced and investors buying the S&P 500 today are not rewarded for the risks they are taking.
The spread on the high yield index is currently trading at around 300 basis points, but the distribution inside the index is very skewed, with more than half of the bonds in the index trading at less than 200 basis points, and 13% of the index trading at more than 500 basis points, see chart below. For more discussion of opportunities in credit see here.
The chart below shows that the last time there were three governors dissenting at an FOMC meeting was in 1988.
On the one hand, dissents can enhance the Fed’s credibility by promoting transparency.
On the other hand, frequent or widespread dissents can be perceived as a sign of internal division or weak leadership.
Academic papers find that dissents have a negative impact on stock prices, and that the lack of clarity in FOMC decisions can lead to increased financial market volatility as investors must price in a broader range of potential policy outcomes. Papers also find that disagreement among FOMC members puts upward pressure on inflation expectations.
For more discussion, see linked materials below.
1. Dissent in Monetary Policy Decisions: Effects, Channels and Implications
2. The Effect of FOMC Votes on Financial Markets
3. Inflation Disagreement Weakens the Power of Monetary Policy
There are emerging signs of weakness in parts of discretionary spending in recent weeks—see chart below—which shows slowing year-over-year growth in consumer spending on motor vehicles and parts, sporting goods, bookstores, clothing, and furniture—sectors that are impacted by tariffs. Our updated chart book with daily data for consumer spending is available here.
The charts below compare the stock performance of Tractor Supply and Apple, Domino’s Pizza and Google, and Old Dominion and Amazon.
The bottom line is that fancy tech stocks are getting so much attention, and investors spend a disproportionate amount of time discussing their growth strategies and new products. But numerous other stocks and investment strategies can deliver better and more stable returns with fewer sleepless nights.
Many people enjoy the adrenaline rush that comes with investing in the latest shiny toy, but for investors looking for steady and stable returns, boring is often a better strategy than fancy.
With the S&P 500 and credit spreads near record levels, it is clear that there is a lot of confidence in the US economy.
In fact, two pieces of evidence suggest that foreign investors are very excited about the US outlook.
1) US 10-year interest rates are going up during New York trading hours and down outside of New York trading hours, see the first chart below. Simply put, this shows that domestic investors are sellers of US government debt and foreign investors are buyers. Unsurprisingly, foreigners like the higher yields they get in the US, including in private credit.
2) While foreigners were selling US assets in April after Liberation Day, they have come back as big buyers of US assets in May and June, see the second chart. In other words, the “sell America” trade was basically only in April.
The bottom line is that the US is the most dynamic economy in the world with some of the most attractive investment opportunities, and the two charts below show that foreign investors agree.
Goods inflation is rising because of tariffs and the depreciation of the dollar, see the first chart below.
There are also signs that service sector inflation is about to move higher, see the second chart below.
What is critical in Fed Chair Powell’s speech today is how confident he is that inflation is moving down toward the Fed’s 2% inflation target.
