“You made a time machine … out of a DeLorean?”

Martin “Marty” McFly

 

Back to the Future

Sometime in the year 1985, a teen named Martin McFly took an impromptu trip. Marty, as he was known to his family and friends, was a musician (he played a mean guitar); although, he was a bit of a “slacker”, who often caught the unwanted eye of his high school principal, Mr. Strickland. Marty, strangely we might add, had a friendship with a somewhat mad scientist named Emmett Brown (“Doc” to his friends), which brings us back to that impromptu trip.

 

Doc, you see, had had an epiphany some years earlier. While exiting his shower, he slipped and fell, hitting his head and according to the police reports at the time – “nearly causing catastrophic injury”. Luckily, Doc survived, but the blunt force trauma to his head inflected by his own bathroom floor, drove the image in Doc’s mind of something very special. This something special would ultimately become the “flux capacitor”, which would help power Marty’s impromptu trip.

 

While it took Doc 30-years to perfect the flux capacitor, he would ultimately attach it to a DeLorean (the coolest car ever known to humankind), creating the first, and, as far as we know, only functional time machine in recorded history (all due respect to H.G. Wells, but there is no way that the Time Traveler’s time machine actually worked). Doc planned to use the time machine himself, but a group of terrorists got in the way (quite common in the suburbs in the 1980s) and before he or we knew it, Marty was, err, driving for his life, leading to that “impromptu” trip back to the year 1955.

 

We would note for the record today that if Marty were to take the same 30-year jaunt back in time, he would travel all the way back to 1993, which is both odd (“hey look, spandex!”) and demoralizing (in a “wow, that makes us old” sort of way). But it is also relevant as we take a jaunt (this one, err, “promptu”) back to the future and roughly the time period at which Marty existed before he went back to the past (and met his mom and kind of kissed her and met his dad, who was a really weird dude, and then beat up a really bad guy and then invented the music catalog of Chuck Berry and then “created” one of the great “nitpicks” in movie history, as in – how do Marty’s future parents who he met in the past not recognize him in the future?).

Back to the 80s

Today we take a journey back to the 1980s as the backdrop of the present day is more and more beginning to rhyme. We have harped long and hard about inflation over the past two years and we thought it would be worthwhile to explore the experience of the time before Marty took his jaunt and compare it with where we are today. Let’s start with a chart and then comment:

Here, we are looking at so called “Sticky CPI”, which incorporates goods that tend to be less sensitive to price changes and are thus thought to better exemplify future inflation expectations. We would specifically focus on the period within the red circle. As you can see, inflation from early 1980 through mid-1981 had come down quite a bit, but then for a period of about 6-months, it rose sharply once again. It is this period that may tell us a lot about the current situation, which brings us to our second chart:

Now, we are looking at the Fed Funds rate over the same period. Again, we would focus on the red circle, which is a period roughly one-year before our red circle from the prior graph. As you can see, heading into 1980, the Federal Reserve had sharply raised the overnight rate in the hopes of bringing inflation under control and by early 1980, it appeared that it was set to declare victory. However, as mentioned, inflation would once again flare up, which caused an about-face from the Fed, pushing the Fed funds rate to heretofore unseen levels of nearly 20%. Okay, let’s add one more chart from back then before segueing to the present day:

Here, we have switched to the 10-year treasury bond. We would again focus on the red circle, which corresponds to our CPI red circle. Now, we are going to get a bit wonkish here, but what we would note is that 10-year bond yields are very much a predictor of sorts of the future of the Fed Funds rate. How, one might ask, do long-term rates predict short-term rates? Simply put – a 10-year bond is simply the average of a series of shorter-term bonds. Believe it or not, one could, if they so desired, buy a three-month bond maturing in 3-months, while also buying a three-month bond that begins in three-months and matures in six-months, while also buying a three-month bond that begins in 6-months and matures in nine-months, etcetera, all the way out to a three-month bond that begins in nine-years and nine-months and matures at 10-years. We won’t get into the how of this (it involves interest rate futures), but one could do it. The yield on the 10-year bond is essentially the average of these 40 three-month bonds that we just purchased. Each of these three-month bonds is essentially a prediction as to where the Fed Funds rate will be at that time.

 

Now, what’s interesting about the early 80s is that the U.S. 10-year yield continued to move up even when the Fed Funds rate was on the way down. This is indicative that investors believed that the average of the Fed Funds rate over the next decade would be higher than previously thought. Why would this be the case? Because investors believed that inflation would be higher than previously thought and thus Fed policy would need to reflect this.

 

Okay, let’s now go “Back to the Future” and pivot to the present day.

 

The Fed does not want to be “a slacker”

One of the perceptions of today’s Fed is that it has studied the period above and does not want to repeat the sins of the past. In other words, it does not want to declare victory over inflation prematurely only to have to pivot on rate cuts should inflation flare up again. As we mentioned before, the ten-year yield would be a good indicator of whether or not investors believed that the Fed would remain higher for longer so as not to repeat the sins of the past, so let’s look at a chart and then comment:

Here, we are looking at current Fed Funds policy vs. the ten-year yield. We would note two things: 1) in late 2022, Fed Funds policy continued to move higher, while the yield on the ten-year moved lower; and 2) Fed Funds policy has largely flattened out over the past few months, while the ten-year has moved to new cycle highs.

 

2022 Investors were Non-Believers

Let’s deal with the first period. Back in 2022 when the Fed was steadily raising rates, long-term bond yields were moving in the opposite direction. Using our prior points, this would be indicative that investors did not believe that Fed policy would be sustained at these high levels for long and that those series of three-month future yield we discussed would actually have a lower average over time. In other words, investors believed that aggressive Fed policy would successfully beat back inflation to the point that future Fed policy would be more benign than previously thought.

 

2023 Investors have “drank the Kool-Aid”

Now for the second period and that recent move higher in ten-year yields. This would be indicative that investors are resetting expectations for the future. The belief that inflation would be brought under control and the Fed would be able to quickly pivot seems to be a disappearing narrative in favor of a higher for longer policy stance. If one wanted to put numbers around it, with current Fed policy at 5.375% and the ten-year yield at 3.5% (where it was in April), assuming the Fed Funds rate stayed at current levels for two-years and then declined, the remaining eight-years of “three-month rates” would have to average 3% to get us to that 3.5% level (note that there is more to the calculation than this, but we are simplifying it so as to not destroy anyone’s brain). Conversely, at the current ~4.6% level, those remaining eight years would have to average 4.4% or nearly 150 basis points higher to get us to that 4.6% ten-year average.

 

So, should we be prepared for higher rates?

Well – no. Investors in 2022 believed that inflation would be brought under control and that Fed policy would be able to change relatively rapidly whereas 2023 investors have a different view. There is no reason to believe one group vs. the other; although, the 2023 group does have an extra year of data to lean on. We would note that if we go back to the early 1980’s, the ten-year yield peaked at 14.6% at the beginning of 1982, but the Fed Funds rate averaged only ~8% for the next 10-years. In other words, these predictions are often way off the mark. Let’s look at one more chart, which exemplifies this:

As you can see, over the ~30-year period from 1982 through 2013 (the last year in which we have 10-years of forward data for the Fed Funds rate), the yield on the ten-year bond was always higher than what the Fed Funds averaged over the ensuing ten-years. Now, we would not read too much into this, but would note that expectations often (or always) differ from reality.

 

Investment Implications

We have seen a sharp correction in markets over the past month. The back up in long bond yields is likely at the heart of this as expectations for higher inflation and a slower moving Fed is bad for stocks. Adding fuel to this fire has been the move higher in oil prices over the past month, which will further complicate the Fed’s ability to pivot. Our view coming into 2023 was that rate cuts in 2023 were unlikely as the Fed had made it clear that it had read the early 80s playbook and it would not look to repeat the sins of the past. Fast forward to today and we are approaching the point at which the bond market appears to have potentially gone too far in the other direction. While inflation remains an issue, the economy has shown clear signs of slowing (especially in Canada), which should provide some inflation relief as we head into 2024. While we think it’s too early to predict rate cuts in 2024, we think it is also silly to rule them out, which seems to be where the bond market is currently headed.