In February, I published “Why VTIP And STIP Are The Stock Market’s Best Groundhogs,” which explained how short-term inflation-indexed bonds would likely lead the stock market lower. Since then, STIP has declined 3.15% (4.4% to trough), and the S&P 500 has slipped 8.2% (18% to trough). Both have risen since the June trough, particularly the stock market, but STIP recently saw a sharp decline, signaling potential weakness for stocks.
Short-term inflation-indexed bonds strongly predict the stock market because higher real interest rates (interest rates after inflation) tend to slow economic growth. Companies and people are still net benefactors of interest rates as short-term Treasury rates are well below the current ~9% CPI inflation rate. As long as that remains the case, saving is discouraged as savings rates are below inflation – indirectly encouraging spending and thereby promoting even higher inflation. Of course, today’s high inflation prevents spending as wages are not keeping up with prices. See below:
Despite the rise in real interest rates, savings have declined – likely driven by negative real earnings growth. This trend has raised the question of whether or not the Federal Reserve is nearing the end of its latest hiking cycle. Short-term real interest rates are no longer trending higher, while long-term real interest rates are seemingly declining – signaling a rapid growth slowdown and an associated decline in short-term interest rates (yield curve inversion).
The stock market has also become very sensitive to the short-term interest rate outlook. Over recent weeks, we’ve seen a slight dovish shift in Federal Reserve signaling and two-quarters of negative economic growth – a traditional recession measure. As rate-hike expectations declined (on poor economic data), the stock market rapidly rose around 4%. The “bad news is good news” phenomenon is not new and was last seen in 2018-2019 when investors clamored over an end to that rate-hiking cycle. Crude oil has continued to trend lower as the economy has slowed, implying a potential decline in July and August’s inflation data.
In my view, stocks are still best avoided as, to me, it does not appear we’re close to the economic-cycle bottom as we’re only beginning to see deterioration in employment data. However, long-term inflation-indexed bonds, such as in the ETF (TIP), might be a worthwhile investment as long-term real yields return to negative territory. However, I believe short-term inflation-indexed bonds, such as those in the ETF (NYSEARCA:STIP), may not rise so quickly as the yield curve continues to invert. Short-term interest rates may need to climb higher before inflation is grounded. That said, STIP remains a crucial tool investors can use to predict changes in economic conditions. Let’s take a closer look.
Short-Term Interest Rate Outlook
Officially, the Federal Reserve’s primary responsibilities are to stabilize prices and employment through monetary policy. They are not mandated to maintain financial market stability but often do so as financial market stability is usually correlated to employment. Today, many companies are seeing EPS decline on tighter profit margins and a slowing economy, increasing financial market instability. However, unlike most previous recession periods, there has not yet been a rise in unemployment while inflation remains exceptionally high by historical standards.
Inflation and unemployment have a robust historical inverse correlation. In general, this relationship allows the Federal Reserve to cut interest rates once unemployment rises. We can measure rate-hike and rate-cut expectations by taking the difference between the two-year and one-year Treasury bond rates. Rate cuts are expected when two-year rates are near or below one-year rates. Dovish shifts usually begin when the GDP and inflation decline at the end of an economic cycle. See the data back to the 1970s:
There are roughly six economic cycles present in this data. During those cycles when inflation was moderate (i.e., 1985-2019), the interest rate outlook became dovish just as annual real GDP growth neared zero. Crucially, in the late 1970s, the last time inflation was as high as today, the economy had to slow much longer before the rate-cut outlook peaked. In fact, the one-year Treasury rate rose to 15%, the same level as inflation, before inflation began to peak around 1980. Technically, this led to two separate recessions (a “double-dip”) as the Federal Reserve was slow to cut interest rates after inflation rose. More simply, prolonged high inflation led to a protracted economic contraction before inflation slowed.
Given today’s high inflation rate, it seems reasonable to assume two-quarters of minor real GDP declines are insufficient to slow inflation. While 2022’s interest rate hikes have been more extensive, they are tiny compared to those pursued in the late 1970s. Of course, today, we struggle with the added layer of complexity that stems from the rapid economic decline and rebound over the recent years. These large exogenous shocks from lockdowns directly halted economic production, creating immense short-term price increases and shortages.
The supply crunch over the past two years was far more rapid than that of the 1970s. Commodity prices have rapidly increased since 2020 but have moderated over the past two months as the economic outlook has declined. This trend may mean inflation will fall without a 5%+ increase in short-term interest rates. Indeed, the five-year expected average inflation rate, derived from bond yields, is 2.85%, meaning the bond market believes inflation is likely to normalize quickly. The moderate decline in the five-year inflation outlook has been matched with a decrease in rate-hike expectations (yield curve). See below:
In early 2022 when the five-year inflation outlook was rising, the five-year bond rate rose sharply higher, and the 5-1 yield curve was relatively high. By March, the five-year Treasury rate had grown enough that the curve began to decline as the inflation outlook moderated below 3%. More recently, there has been a sharp deterioration in the 5-1 yield curve, signaling an interest rate peak at ~3-3.25% or 75 bps higher than today’s discount rate. Currently, the market anticipates a 50 bps hike next month, followed by a 25 bps hike and no further hikes.
Everything Depends On Crude Oil
If the bond market’s inflation discount level is correct, then short-term interest rates are unlikely to rise much higher. This outlook is logical as the US economy is now in an evident slowdown, and while unemployment remains low, rising initial jobless claims signal a slight expected increase. The “10-2” yield curve is exceptionally inverted, signaling a continued slowdown and a prolonged period of interest-rate moderation. If these outlooks prove correct, STIP would be a relatively safe bet to deliver slightly positive net annual returns of ~50-70bps after inflation over the next five years.
However, the bond market, mainly driven by global central banks, commercial banks, and large investment institutions, may not fully understand commodity market dynamics. Since 2020, the bond market’s inflation outlook has been closely tied to the price of crude oil. Until May, commercial crude oil and petroleum product reserves declined as low global production and rising demand drove a shortage. Crude oil and the inflation outlook peaked then and have fallen since. See below:
The blue line above represents total US crude oil storage, including those in the Strategic Petroleum Reserve. Total oil stocks have declined at an accelerated pace since May as the US government has dramatically increased SPR releases. Retail gasoline and crude oil spot prices are primarily driven by changes in commercial inventories (since it is costly to store oil and gas), so the dramatic increase in supply from SPR inventories has caused crude oil (and therefore the inflation outlook) to decline quite dramatically over recent months.
In the short term, the SPR oil release will likely depress the inflation rate, allowing the Federal Reserve to slow and end interest rate hikes and potentially mitigate the economic demand slowdown. The SPR will be empty in around 18 months at the current pace of declines; however, I expect the SPR withdrawal will need to end before then as it would be problematic to have no emergency reserves. Given total oil storage continues to decline, commercial oil storage levels are likely to peak sometime over the next six months and are likely to fall after that as there is little evidence of new production growth. If the correlation between commercial oil storage, the oil price, and the inflation outlook remain, this may mean the inflation outlook will rise even higher once the Biden admin slows SPR releases.
The Bottom Line
This situation may be similar to the late 1970s when interest rates needed to rise to double-digit territories before inflation came down. As in today, the 1970s “Great Stagflation” was fundamentally driven by a decline in the global oil supply and was exacerbated by the Federal Reserve’s unwillingness to hike interest rates (until the “Volcker era”). Of course, today’s situation is seemingly moving quicker than it did then. Still, I do not believe we’ve seen the peak in interest rates or inflation until total crude oil inventories rise (either through demand destruction or new production).
In the short run, there is little evidence suggesting short-term inflation-indexed bonds should decline much further. There is also not much evidence pointing toward a rise in short-term inflation-indexed bonds since both the short-term interest rate and inflation outlook have moderated. However, if my thesis regarding the connection between the SPR oil release and inflation expectations proves correct, then the Federal Reserve may need to increase interest rates much further. This scenario is likely bearish for STIP as real interest rates may need to rise before economic demand finally declines enough to slow inflation. Overall, I do not see STIP falling much more in the short-run but may see another wave lower later this year if crude oil rises again.