Executive Summary
  • Resurgence of Covid cases and the anti-vaxers could dampen economic activities and thus diminish demand driven inflation pressure.
  • The U.S. economy has likely passed peak growth, and the path forward (rate of slowing growth) will depend on the resurgence of Covid cases which could dampen economic activities and thus inflation pressure.
  • Speedy reduction of employment slack, especially in the lower income economic sectors, would support increasing aggregate demand which would contribute to higher inflation.  Labor data, although speedily improved, has stalled, and the number of unemployed plus the number of workers not in the labor force remain high.  The speed of labor market recovery, which is a focus of the Fed, will partially be dependent on the path of Covid/Delta resurgence.
  • Much of the inflation is transitory, but since transitory is not defined, we believe that peak inflation is likely behind us. However, there will be a longer tail of above 2% inflation for some time, and it is not just transitory.
  • If peak growth and peak inflation are behind us, the Fed will have more time to wait before taking action.  The technical factors are pushing interest rates lower and are not structural. This should dissipate by the year-end, and we expect 10-year treasury to rise from closer to 1.75% to 2%.
  • The Fed has a new framework of abandoning an ex-ante approach of taking action in anticipation of a change in favor of an ex pose approach of witnessing the data with a trend fully established and then take action.  This approach, by definition, is reactionary and, as such, would likely be late. (A hotter economy leads to higher, more sustainable inflation above 2%.) The Fed’s insistence that the current inflation is transitory and the desire to bring employment equity to all have been consistent and that means lower rates for longer…for now.
  • The next two quarters will likely be jagged for the stock market since it continues to reach higher highs and is priced for perfection.  At this point, it is not too hard to be disappointed and the market takes a tumble.  Similarly, bonds are very richly priced with spread getting ever tighter (a result of the sustained dovish monetary policy).  There is also very little room for error.  We are concerned with the potential positive correlation between stocks and bonds going forward and the benefit of diversification vanishing.

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