Published on October 18, 2022

The Fed remains singularly focused on containing inflation but has made little headway so far. We anticipate the tightening cycle will continue, which will keep downward pressure on risk assets.

It’s Like Déjà Vu All Over Again … Again

Indeed, the more things change, the more they stay the same. As we wrote last quarter, the Fed continues to be singularly focused on containing inflation but has made little headway so far, despite two 75 basis point hikes in the fed funds rate. We suspected it might take time for tightening monetary policy to filter its way through the economy, and in this regard we have not been disappointed. Financial markets, on the other hand, have reacted much faster and continue to reprice risk, with higher yields and mostly wider corporate and mortgage spreads.

There are subtle signs that the Fed’s restrictive policy is beginning to have the desired effect on a few forward-looking inflation indicators, and it is also impacting interest rate-sensitive sectors, such as housing. While core CPI remains near its local high (6.3%), core PCE has dipped from its February peak of 5.4% to 4.9%. Our preferred index is the full data set measure of the Underlying Inflation Gauge (UIG), which mirrors core PCE’s drop – it fell from 4.9% in March to the latest reading of 4.5% (for August).

One reason we favor UIG – besides its advertised goal of identifying the persistent component of inflation – is that it eliminates a lot of the monthly measurement noise and volatility that can plague the other indices. UIG shows a definitive peak and several months of falling inflation, which is a promising development in this fight to curb rising prices. Still, 4.5% remains well above target and much more work is left to be done.

Turning back to the Fed, we see little change in the trajectory of its current tightening policy. The most recent “dot-plot” of forward rate expectations of Fed members has recast higher to more realistic levels. The relative resilience of the economy pushes our expectation for that elusive terminal rate hike higher – and further into the future.

Confounding the Fed response to this inflation event is its stubborn adherence to a 2% inflation target. We believe the current neutral rate of inflation is higher than 2% - we estimate it to be between 3-4% at present. If the Fed employs a restrictive policy that sticks with a 2% target, it is clear to see the potential for policy error.

Looking at rates, we continue to expect short rates to rise. Liquidity has been challenging in fixed income markets and we can no longer ascribe this to a seasonal summertime lull – large moves have become the norm in recent weeks and should continue, especially as global bond markets struggle to find their footing. Inflation has proven to be a global phenomenon, although Europe (as an energy importer) has fared significantly worse due to skyrocketing energy prices and the geopolitical uncertainty therein.

This leaves us cautious in U.S. fixed income markets. Risk rallies are severe but short-lived. Spreads are wide but can continue to stay wide or even widen further – especially in corporate bonds. The yield curve is inverted (2- and 3-year yields mark the peak at the time of this writing) and should continue to be relatively flat/inverted so long as the Fed raises rates. We expect the specter of recession will ultimately provide a bid to Treasuries, but we aren’t there yet. At present, we prefer yields realized in cash and high-quality commercial paper, until we see definitive signs of a pivot in Fed policy or the economy.

We would like to thank you again for your confidence in the team and welcome any questions or comments you may have.

Eddy Vataru

Chief Investment Officer – Total Return & Lead Portfolio Manager

John Sheehan

Vice President & Portfolio Manager

Daniel Oh

Vice President & Portfolio Manager

Past performance does not guarantee future results. This commentary contains the current opinions of the authors as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. It is not possible to invest in an index.

No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.

Consumer Price Index (CPI) reflects the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.

The PCE price index, released each month in the Personal Income and Outlays report, reflects changes in the prices of goods and services purchased by consumers in the United States.

The Underlying Inflation Gauge (UIG) captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data.

The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on an overnight basis.

Spread is the difference in yield between a risk-free asset such as a Treasury bond and another security with the same maturity but of lesser quality.

A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.

Treasuries (including bonds, notes, and bills) are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.

A basis point is a unit that is equal to 1/100th of 1%.