By Tim Courtney, Chief Investment Officer
2022 was the year we were reminded that inflation is a risk, even in a developed and relatively efficient market like the U.S. Inflation came in high and forced interest rates higher. While the two should be related, the market was clearly focusing its attention on the Federal Reserve and interest rates. The 10-year Treasury yield peaked at about 4.5% while stock prices in general fell, but then reversed and dropped to 3.8%1 while the market rallied. This decline in interest rates continued into January 2023 (while the rally continued) and the 10-year yield eventually fell to 3.3%.2 Many assets such as cryptocurrencies, higher priced stocks, unprofitable companies and REITs that were decimated by rising rates in 2022 experienced a surge in value.
With inflation on a downward trend, many investors hoped interest rates would keep falling and that markets could return to the “party time” we saw in late 2020 through 2021. However, in February a different story began to unfold. The 10-year Treasury yield rose back to 4%3, slightly higher than its closing value at the end of 2022, and markets quickly began falling once more. But still inflation, earnings, a recession – all of these are secondary to the market’s obsession with the Fed’s next interest rate move.
The market’s fixation on the Fed is understandable since central banks are the market referees, and they contributed to the inflation problem by lowering rates to zero. But this obsession ignores some pertinent facts, one of which being that rates are still below the current level of inflation. Another is that rates can’t address some of the other causes of inflation such as deglobalization and continuing shortages in labor markets.
Ultimately, inflation remains the investor’s public enemy number one. A 6% rate of inflation is about double the average inflation of the last 100 years and is a friction (like taxes) that eats away at our purchasing power.4 We had inflation under control for so many years that outside of the Silent and Baby Boomer generations, investors have no memory or experience in dealing with it. Younger generations are having a rude introduction to inflation.
One good bit of news is that inflation has been slowly falling, and the amount of money in the economy has also started to slowly shrink (albeit after growing by 40% from 2/2020 – 2/2022).5
Whatever the Fed eventually does, it remains a good idea to be diversified, and to have exposure to assets that should do well if interest rates and inflation remain higher, as well as to assets that should do well if interest rates and inflation recede. No matter what direction the Fed takes with its monetary policy, it’s important that investors keep their eye on the bigger threat of inflation now that it’s back and likely not moving back under 2% anytime soon.
- CNBC (12/30/23) — Treasury yields rise slightly on final day of 2022, 10-year yield ends year below 4%
- Forbes (1/25/23) — 10-Year Treasury Yield Drops In Response to Falling Prices
- The Wall Street Journal — The 10-Year Treasury Yield Tops 4% for First Time Since November
- Ycharts (1/31/23) — US Inflation Rate
- Federal Reserve Economic Data (2/28/23) — St Louis Fed, M2 Money Supply
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