Aug. 9, 2021

Can denial defeat inflation?

Guests: Todd Thompson, CFA, Managing Director and Portfolio Manager, Dimitri Silva, CFA, Portfolio Manager, and Steve Masarik, CFA, Client Portfolio Specialist, all of Reams Asset Management

In this episode of Markets in Focus

The inflation debate is intensifying as fears rise but markets seem to be shrugging. What’s driving the disconnect and what happens if, and when, it gets resolved? Todd Thompson, CFA, Managing Director and Portfolio Manager at Reams Asset Management, and fellow Reams Portfolio Manager, Dimitri Silva, CFA, join Steve Masarik, CFA and Portfolio Specialist, to discuss how inflationary trends could impact the markets into 2022.

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Steve Masarik:
The recent action in the U.S. treasury market has been quite interesting, and even perplexing in some regards. U.S. GDP growth is strong, recent inflation numbers have been well above trend, and the tone of the June fed meeting was slightly more hawkish. Treasury rates must surely have gone up, right? The yield curve must have steepened. Not so fast, my friend. Rates have, in fact, taken another leg lower and are materially below the level seen in March, long rates at least, as the curve has also flattened with some upward pressure on rates at the short end continuing into the second quarter. The bond market, and more specifically the U.S. treasury market, is widely viewed as the smart money when it comes to divining the macroeconomic landscape. Is there a deeper message about growth and inflation that we should be paying close attention to right now?

This is Markets in Focus from Carillon Tower Advisers. I'm your host today, Steve Masarik. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Be sure to subscribe for new episodes and visit us at for additional insights. Joining me now are Todd Thompson, managing director and portfolio manager at Reams Asset Management and Dimitri Silva, portfolio manager at Reams Asset Management. Todd and Dimitri, welcome.

Dimitri Silva:
Hi Steve.

Todd Thompson:
Thanks Steve.

Steve Masarik:
So Dimitri, let's kick things off today with you. What exactly is the bond market telling us right now? And if it's telling us anything, if there is some signal among the noise, should we be listening?

Dimitri Silva:
Great question, Steve. As a recap, what's happened in the bond market is, long dated yields have come down pretty significantly, while the intermediate to short part of the curve hasn't moved that much. What we've seen is that if you think about a long-term yield of a five-year rate, it's come down roughly about 75 basis points since the end of the first quarter. But what you've also seen is that's been primarily driven by real rates. So if you look at inflation expectations, which is the other component of nominal yields, they've essentially been unchanged since the end of the first quarter, but you've had a significant drop, about 70 plus basis point drop, in five-year real yields.

Now, what does that tell us? Well, before I say what that tells us, I think there's a reason for it. A couple of reasons that's possible. First of all, we've seen COVID make a bit of a comeback, the Delta variant specifically, increasing the number of cases globally. That's been one of the drivers where people's expectations for growth, I think, have come down. Even if you look at a different market, like the equity market, what we've seen is a significant de-rating of growth as implied by the equity market. To give you some sense of the numbers, for one of the metrics that we look at, it's essentially given back all the growth expectations since the beginning of this year. So for example, growth expectations picked up very significantly as we had COVID vaccination start up, as well as the prospects of a divided Congress go away, at the beginning of this year, you had growth expectations as priced by the equity market go up pretty significantly.

But we've had somewhat of a roundabout tour since the end of the first quarter where essentially they've given it all back up. And we think COVID has definitely been one big driver of it. Even though, to us, we think that this is more of a short-term in nature, and that's something that should be faded. It's clear that the market's been worried about this. And as a function of that, you've seen people who had extended short positions in the bond market cover those positions. The market was very much biased toward steepeners at the beginning of the year and through the first quarter. And what we've seen is some of those positions get unwound as growth expectations have fallen over these last few months.

Can we explain where long data real yields, currently where that negative 70 basis points? Can we explain that fundamentally? No. What we think is, these are due to some technical flows specifically by foreign central banks, who have been big buyers, as far as we can tell, based on some of the metrics that we look at, especially in the futures market. They've been big buyers of bonds. They essentially liquidated some of their holdings and treasuries back in the first and second quarter of 2020 during the crisis. We think they're putting some of that money back into the market. And when that's happened, given the size of those flows, it can have significant impacts. So all in all, we've had a de-rating of growth, no questions asked, as per the market. But does it justify long dated real yields at where they are currently? No.

Steve Masarik:
Great. Thanks to Dimitri. So I guess just sticking with this question for a moment, do you think there are any clear messages about long-term growth and also inflation, aside from some of the technical features that have been impacting rates? What about intermediate and long-term macroeconomic views? Is this drop in long end rates along with some upper movement at the short end telling us anything that we should really be paying attention to from a macroeconomic perspective?

Dimitri Silva:
Sure. If you look at where those, especially the long-term real yields are, so-called five-year forward real yields are, for the U.S., it's currently trading at negative 70 basis points in the area. And it would be somewhat inconceivable, once again, to assume that growth expectations for the U.S., long-term growth expectations of the U.S. are at those types of depressed levels. Clearly, interest rates are not only governed by long-term growth expectations, but supply and demand factors. But we think that those are somewhat, especially as The Federal Reserve starts talking about tapering, we get to somewhat of a more normal supply/demand balance. We don't think that these types of growth rates, as implied by the bond market, are likely to be consistent with what's going to happen over the longer term.

Steve Masarik:
Todd, let's turn to you for this next question. It's been well documented that U.S. inflation, as measured by the consumer price index or CPI, has struggled to hit 2% consistently in the post GFC (Great Financial Crisis) period, and has not been what most would call problematically high since really the 1980s. So despite this long trend of benign CPI inflation, it sure feels like we have significant inflation out here in the real world. Inflationary pressures really seem to be everywhere at the moment. Yet the full extent of this is not being reflected in consensus expectations for future inflation. Where is the disconnect? And what happens if, and when, that disconnect gets resolved?

Todd Thompson:
Great question, Steve. First thing I'd like to talk about is how do you measure inflation expectations? And one of the first issues really need to tackle right away is, you can't use the TIPS (Treasury Inflation Protected Securities) market, which is aggravating to some, because it was built as a market to be able to express an opinion on inflation expectations, implied by the market. And unfortunately, that market, if you were to look at implied inflation, it's in the low 2s. It did creep up to, depending on the maturity, you're looking at 5 to 10 years. It did go up to around 2.5%, But it has come back down to high teens or around two and a quarter. And that is abnormally low with, as you alluded to before, inflation that is, depending on your yard stick, somewhere in the year over year 4 to 5% range right now.

And the question is, why can't you use the TIPS market? Why is it invalid at this time? And we believe the main reason for that is The Fed purchase program each month whereby the quantitative easing program they're working on is 80 billion in treasuries a month, in addition to 40 billion of mortgage backed securities. A large part of that 80 billion happens to be treasury inflation protected securities. And as a proportion of outstanding treasury inflation protected securities, it's rather large, in so much that it's enough to distort the supply/demand equilibrium of those securities. Said in simple terms, they have bid up the prices. The yields have fallen. And the resulting implied inflation is distorted because of those purchases. There's no natural equilibrium by which to draw information content.

So you have to move on, in our view, to something else away from that. There are several indicators out there. The Fed will often mention these in their correspondence. University of Michigan survey has various components, in addition to the conference board. And the New York Fed as well has other surveys to be able to glean inflation expectations, not just in the near term, but also for the long-term. But those inflation expectations are elevated, not as high as current readings. As an example, the University of Michigan survey, the near-term number for them in regard to one year out has a rating of 4.8%. But their survey for longer-term expectations, 5 to 10 years out, is much more modest at 2.9%. It's higher obviously than the level we've been trending at for the last decade, at two or less. But 2.9% is still relatively subdued, and doesn't really represent a regime change or fundamental permanent change in the level of goods and services inflation in the future.

And so, I do concur that there is a disconnect. Expectations are relatively subdued. And how does that get reconciled? I believe one of the reasons you can attribute why these expectations are low as the market has embraced The Fed's rhetoric about this being a transitory phenomenon. You saw rates rise relatively sharply in the first quarter, but have since come back. But The Fed has kept on that drum beat about this being temporary. These are short-term supply situations that will recede. And they've been saying it so much that the market has seemed to believe it, hence rates coming down in the second quarter. So I believe the first issue is that the market believes it.

The second issue I want to draw your attention to is what I call a recency bias. And that is, it's been quite some time. It's been the 70s and 80s, the last time we've had debilitating inflation. And as time has rolled on, there's now three decades since then, a lot of those market participants and people involved in these surveys have moved out of the cohort. And now you have a younger cohort who's predominating those surveys. And so, those people don't remember the ravages of inflation, and more or less, will have a recency bias of mentioning and only remembering what they know from their recent past, which is more subdued or 2%, give or take, inflation. And even in the last decade, even between one and two. And so I believe there is definitely an ingredient of that that goes on in regard to expectations right now.

I want to point out to you a little bit inside of the New York Fed survey of inflation, they actually provide the granularity whereby they stratify the responses by age. And you'll see exactly that phenomenon, which I just mentioned. The under 40 cohort has the long-term inflation expectations of 3.08. The 40 to 60 cohort has 3.55. And the greater than age 60 cohort has in long-term inflation expectations of 4%. So you'll see that the older people who remember what happened in the 70s and 80s will definitely acknowledge the possibility of a flare up again. Whereas the recency bias of the younger generation, more or less, understates the threat of inflation. So I believe that's really what's going on now in regard to why there's a disconnect. We're believing the transitory. And I think there's too much recency bias.

Steve Masarik:
Thanks, Todd. Those are really great insights on the current inflation picture. Changing tack just a bit. Much has been written about the need for The Fed to normalize monetary policy, as well as the appropriate timing and sequencing of those actions. Less has been written about the ability of The Fed to normalize policy. Some claim that the U.S. is mired in a Japan-style liquidity trap that will, in combination with a significant debt overhang, place a natural ceiling on interest rates, and perhaps curb long-term GDP growth. Dimitri, what are your thoughts on these topics?

Dimitri Silva:
Great question, Steve. I think a lot has been made about how there's a Japanification of the world, and that U.S. has following that path. But if you look at the numbers, I think it's very clear that the Us is very different from Japan. For example, the working age population in Japan has been shrinking for the last 25 to 30 years, since the mid 90s. And it's down about 15% since then. For the United States, primarily as a function of immigration, the working age population of the country has been increasing and is expected to increase all the way through 2060. So in that environment where you still have positive population growth and some productivity growth, you expect real GDP, definitely to be lower than what it's been historically, but not to follow the same path that Japan has over these last 25 years.

It's also interesting to think that one of the other reasons why we think this is more technical in nature, rather than fundamental in nature, is that if you think that Japan has very poor growth prospects and hence they should have lower real yields, what you see today is, even on a long-term basis, on a five-year, five-year or 10-year, 10-year basis, the U.S. actually has lower real yields today than what Japan does. So that is a good gauge for us to understand that this is much more of a function of clearly a big buy in the market, more price insensitive buyers in the market, that it can distort a supply/demand, as Todd mentioned. But this is a short-term phenomenon. We believe that, over time, U.S. real yields will get back to where they were pre COVID, which was 50 to 70 basis points higher. That will be more in line with where real neutral rate would be.

Now, if you take a step back, as I mentioned, the real neutral rate is not just as a function of current growth, but it also is impacted by savings versus investment imbalances, as I mentioned. But something that has held back real neutral rates over these last 25 years have been things like low dependency ratios. A dependency ratio is essentially talking about how much of the population that's either under 18 or over 64 versus a working age population. And even though you'd think, hey, we've had a population that has been aging for a while, the United States has actually had a lower dependency ratio over the last, call it, especially up till about 2015. The reason being that we've had a lot of younger people, essentially a lower number of younger people, as well as having a higher number of older people. So the dependency ratios have been coming lower. But what we've seen is that has turned since 2015. And what we're going to get is, savings are going to have to get drawn down as the dependency ratio of the working age population starts creeping up. That's one reason.

The other reason is, we've had emerging markets savings clubs. So essentially, world reserves as a percentage of GDP from say early 2000s, all the way up to the 2010, went up from something like 40% of GDP to 100% of GDP. So when you have those dollars being essentially recycled back to the United States, that has an impact of bringing down real neutral rates. But what you've seen in since mid 2015 is, that's stayed pretty flat, suggesting to you that you're not getting these large changes in aggregate savings that gets recycled back into assets, investments, and hence reduce that real neutral rate.

So long story short, we think there's a turning in terms of those long-term supply/demand factors. Plus we think that trend growth, while it's lower than it's been over these last 25 years, is not going to significantly drop so as to suggest that you'd have a real neutral rates of negative 70 basis points for the United States. We just don't think that's fundamentally sound.

Steve Masarik:
Maybe a follow-up question on The Fed's ability to normalize policy, you've removed QE and eventually move off of the zero policy rate. How much scope and ability does The Fed actually have to raise interest rates and to stop their large scale asset purchases? What is your sense of the end game here for The Fed?

Dimitri Silva:
I think it goes back to that question of whether we are becoming Japan in some form. And as I mentioned, I don't think that's the case. Clearly, The Fed having a balance sheet that's way larger than it's been historically, as a function of GDP, and how they normalize that over time, is going to be an interesting factor. This is unknown. We haven't had this type of normalization. We had a small normalization that took place of the balance sheet, call it, right around 2017 and 2018. That didn't go too well. So there are definitely more questions than answers there. But all in all, we do think that especially in this cycle, given how growth is likely to be very robust, given we have quite a bit of excess savings left in the system that can be spent. There is a sense that, clearly fiscal policy after, for a while, being on the dormant part, now fiscal policy is opened up, which will possibly increase public investment, hence will be hopefully something positive for real GDP over time.

So, as a function of some of these things, as I mentioned, the fact that trend growth in the U.S. is nowhere close to what it's in Japan, and the fact that there are some short-term benefits in terms of excess savings that consumers have, plus the fact that the fiscal policy is likely to be relatively accommodative over the next few years, given the fact that there's definitely a lot been done, while yes, we've talked a lot about these things, but they have not actually been executed yet. And that will flow through in the next four or five years. But the point being is that, we still think that the United States can normalize policy. It will be a challenge, no questions asked, given the size of the balance sheet. But we think they'll get there.

Steve Masarik:
Okay, thanks. Final question today. This one for you, Todd. And it ties back to the discussion about the disconnect, in terms of inflation expectations and what we all feel like is accelerating inflation. Every time we go to the store and we pay for something, there are some interesting and potentially very impactful dynamics at play right now in global supply chains, as well as the domestic labor market. What are these trends telling you? And how does Reams expect these to play out over the course of 2021 and into 2022?

Todd Thompson:
Thanks Steve. That's a great question. In regard to the supply chains, they've obviously been very stressed. When you have an economy that went into a retrenchment mode not knowing how long the shut-in would transpire, and then to have it turned around relatively quickly, the early part of 2021, it would stress the system. It wasn't ready for a vivacious turnaround of demand and consumption. And we had done so much retrenchment that it felt a lot more chaotic than what it is. This economy is very dynamic and has, for decades now, run on more of a just in time inventory and process for the sake of capital efficiency. And that is not abating at all.

In fact, I'll give you one example of this. The railroad industry, which is a very large component of industrial logistics across the United States, has implemented what is called precision scheduled railroading in the last five years whereby they're using less cars and less people by operating on tighter schedules. Well, they have been hit particularly hard by the abrupt resumption of demand, as they have been caught short of cars to be able to accommodate what the demand has been. But we're seeing that process play out everywhere, and has spilled over into goods and services prices. We've had shortages at different various commodities that have played through too on the food side. And the much publicized issue with the chips in Taiwan that affected the whole auto industry has been much publicized as well.

We see a lot of these as likely to abate. Again, the economy that is this dynamic will adjust over time. Those replacement of the chip sets will occur sometime in the second half this year and relieve the pressure on new cars as well as used cars, and the spillover effects into the rental car markets. So we expect that to abate, as will other parts of the economy in regard to these supply chain issues. So overall, much of what we're seeing in inflation, definitely will be proved to be transitory as these pressures are relieved.

However, one area that is a particular concern to us, away from supply chains, is really on the labor side, which in and of itself is a raw material for the business world, is human capital. And there's a shortage right now. We have an estimated of over 7 million jobs looking at where the employee levels were before the pandemic. There's still over 7 million people still less in the workforce than there was then. There's over 8 million jobs, openings, right now. And there seems to be a disconnect where the employment gains have proven to be less than expected every month for various reasons have been given, including the lingering federal subsidies in regard to employment benefits that were added onto state benefits, that has discouraged workers. There's that issue that's been talked about. There has been the issue of inadequate childcare that has been bandied about, in addition to concerns about health and safety with COVID for people returning to public workplaces.

One additional one, that is probably one of the most widely discussed one, is a mismatch of skills versus what demand is in the market, and available skills of those workers. All these have been various factors that have cited for why you have not been able to draw down the available jobs quicker and match those people in the marketplace. But it seems to me that, for whatever the reason it is, there is a shortage of workers, particularly at the lower wage end of the spectrum, including hospitality and retail. That is going to be a challenge to be rectified.

Before the pandemic, president Biden was discussing the desire to have a $15 minimum wage legislated. Well, it seems that it's possible to have almost something higher than that without legislation, just because of the pressure of trying to fill these jobs. We're seeing several businesses use signing bonuses and the like, in addition to higher stated wages, to be able to draw these people off the sidelines. This could prove to be one catalyst for higher inflation, as it could lead to higher income, translating to higher consumption, and be more of a push issue into the system. So that's one issue that we're focusing on, probably more so than the supply chain. We think the more stress point that should be of concern to investors is really on the labor front.

Steve Masarik:
Great, well, Todd and Dimitri, thank you very much. Those are great insights. And also, thanks to everyone out there for listening to Markets in Focus from Carillon Tower Advisers. Remember to subscribe to our podcast on Apple podcasts, Spotify, or wherever you listen to podcasts. You can also find additional market insights at Thank you, everyone.


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