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No surprise, inflation came in hot in the US. You only have to turn on a US news channels and see the rising gasoline and grocery prices to know it was coming in above expectations. What may be worse though is prices are not abating in June so next month, the numbers could be even worse. In the meantime, the Federal Reserve may be forced to alter its “measured approach” to combating inflation by raising short term rates by more than 50bp. Some Wall Street wolves are howling for a full point to settle the debate immediately by shocking consumers into the fetal position. Mind you given the conversations from CEO’s and CFO’s this week, that may not be enough. It seems Covid has created an atmosphere of complacency and work from home regardless of benefits presented to employees. The last bullet in the gun will be bigger signing bonuses to get workers back to the shop and those costs will either be passed on to consumers in terms of higher prices for goods and services or they wont, in which case, profit margins will rapidly erode.

Regardless, a full point rate hike could spell the start of a recession. First Quarter US GDP fell 1.5% and so far the second quarter does not look much better. If the Fed hikes too aggressively this summer, the cost of financing a house or auto could become prohibitively expensive, or it will eat up a larger portion of those consumer’s disposable income. Small business owners will then feel the squeeze as shelves fill up with slow moving inventory possibly forcing them to reduce staff to reduce costs.  But maybe that is the point.

Maybe central bankers need to take a page from Paul Volker’s playbook. In early 1979, inflation was running at 10% heading to 13% by December. Fed chair Volker took up the challenge and hiked rates from 11% in August to 15.5% by Halloween. No surprise it triggered the start of a short-term recession, but it looks the Fed didn’t realize it even though stock prices were tumbling… actually the US market peaked in 1973 and incurred a lost decade until it bottomed out in the summer of 1982. But I digress. The point is Fed Chair Volker did not hesitate to raise rates aggressively to fight inflation expectations. Fed Funds rate hit 20% in March 1980, fell to 8.5% by June and back to 20% by December.

Looking back, it was a roller coaster year and if nothing else, when I look back on those years, the one thing I remember is watching gas prices leaping up every time I stopped at the pump or at least it felt that way. Of course, that was the year Mr. Trudeau got back into power, redefining his socialist policies by taxing everyone. So perhaps I was just a little jaded spending my summer working forty miles into the bush from Fort St. John. I think it was also the first year I qualified for a student loan, or perhaps it was 1981 when interest rates were at loan shark rates.

Regardless, we will know next week whether Mr. Powell will stick to his measured approach, or get a little more aggressive and hike rates by more than 50bp. This would open the door for even more aggressive hikes should inflationary pressures keep building, but runs the risk of tanking the economy like Volker did 40 years ago.

The question is how should investors allocate their savings? Gold worked out well this week but that may be short lived. Mind you both Barrick and Newmont have dividends north of 3%. Energy also held up well this week…no surprise with crude sitting at $120 barrel US$.  The pundits believe we believe we are reaching a peak in bond yields in the belief that governments will not be able to pay the interest on their debts. I would argue, Central banks could keep pushing rates even higher while at the same time, reverse course and continue to buy newly issued government debt. That would keep the tap open to finance their spending programs while at the same time chocking off the consumer.

That may or may not be good for banks short term but longer term, banks make more money on their credit spreads as interest rates rise, so with the latest pullback, they are getting attractively priced…in my opinion. And judging from the headlines, real estate rents are not exactly falling, so we are keeping our eye on senior housing and warehouses.

Bottom line, I would not make any bets until Wednesday after the Fed announces the rate change.

Happy trading and stay safe.

Cheers Steve.

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