Fear of the return of inflation

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How much is inflation priced in?

More and more market participants and pundits are betting that a stall in inflation's decline could prevent the Fed from cutting interest rates at all in 2024. Inflation reports in the past two months have been very hot, and the Fed's recent talk has seemed somewhat hawkish. For months, markets have been pushing back on expectations of interest rate cuts. Now, the market's implied year-end rate is exceeding the Fed's latest interest rate forecast. Could the gap widen?

On Wednesday we'll see new consumer price inflation data, which could make the hot January and February reports look like the anomalies many experts insist they are. If not, it would look as if inflation had stabilized at around 3 percent. Economic growth appears strong. Nominal wage growth is about 4 to 5 percent, a level that is historically incompatible with an inflation rate of 2 percent. Data this week on consumer inflation expectations, which the Fed sees as key to inflation, were not encouraging. The three-year forecast rose, rising to 2.9 percent from 2.7 percent. Inflation expectations for next year fell sharply last year, but have been stuck since December at 3 percent.

With growth as strong as it is, there is a growing consensus that the most likely economic outcome is a “longer-term higher soft landing,” JPMorgan's Marko Kolanovic said in a note Tuesday.

How easily will markets absorb stubborn inflation, resilient growth and high interest rates? To get an idea, we took a look at how much inflation was priced in. Supporting near-term inflation expectations from market prices is not easy. You should conduct an extensive survey and make your best guess.

The most surprising recent development has been the market for inflation-linked bonds. Two-year inflation breakeven rates (the yield on vanilla Treasuries minus the yield on inflation-linked bonds, also called tips) started the year at 2 percent, but have risen to 2.8 percent. This measure is based on the two-year tips market, which is a weak market and should be taken with caution. But more reliable long-term breakevens are on the rise too:

This sounds to us like caution, not panic. Inflation levels are linked to the US Consumer Price Index, rather than the Personal Consumption Expenditure Price Index that the Fed targets. This is important because of the historical “wedge” between CPI inflation and PCE inflation. Over the past three decades, headline CPI inflation has averaged about 40 basis points above personal consumption expenditures. So a CPI swing at 2.5 percent, as the five-year break-even suggests, is almost consistent with the Fed's 2 percent inflation target for personal consumption expenditures. Nerves in the short term, confidence in the long term.

A similar note of caution is evident in the futures market. The conditional result this year is still cuts; Currently, three of them are priced. But other scenarios seem more likely. According to the Federal Reserve Bank of Atlanta's interest rate market tracker, since February, the probability of no cuts in 2024 has doubled, to 10 percent. The chance of an interest rate hike this year has also increased from 5 percent in February to 8 percent now. These are still tail risks, but their tails are getting fatter.

Interestingly, the inflation swaps market has been relatively quiet. The five-year/five-year forward rate, which measures the market's expected inflation over the five-year period beginning five years from today, has risen only slightly. The two- and five-year rates began 2024 at 2.5 percent, in line with its 20-year average. Today, it has reached 2.6 percent.

In stocks and commodities, you can also provide evidence of the pricing of inflation risks. The chart below shows several assets that are reasonably sensitive to inflation. The last, in blue, is an actively managed inflation-hedge ETF that combines exposure to inflation-linked bonds, commodities, real estate, and resource extraction stocks. It has bounced since February:

This is circumstantial evidence. The recent increase in oil prices has as much to do with geopolitics as it does with strong global demand, gold's rise is puzzling analysts, and industrial metals are being supported by a rebound in Chinese demand. But on the margin, this adds to the case that inflation nerves are creeping in.

Overall, this is a picture of markets calmer than panicked, but alert to the inflation risks that remain. (Ethan Wu)

Responses to private equity excess returns

Yesterday's article about excess returns in private credit elicited a lot of meaty responses from readers, on all sides of the discussion.

Edward Finley of Arrow Wealth Advisory LLC noted that from a certain point of view, the question “Does private credit, as an asset class, generate excess return” is a bit of a category error:

An asset class (properly understood) is a set of systematic risks. By definition, this is not something that should generate any returns beyond its systematic risk. . . It is strange for anyone to show that the average high-yield fund does not achieve returns that exceed the risks it takes and think it has proven anything useful.

There is something to this. Understanding excess returns as additional returns that do not come with additional risk should not be a feature of an asset class in even a moderately efficient market. It's free lunch, and in a functional market, lunch either stops being free, or it gets eaten entirely.

Most of the people who said that there were excess returns to be harvested argued, more or less, that those returns were functions of frictions in lending markets, frictions that private credit funds could impose on borrowers in exchange for removing them.

Here, for example, is Marco Hanig, CEO of Alternative Fund Advisors:

The main reason for excess returns is the “source premium”. . . Neither individual nor institutional investors can invest directly in a private loan. The loan must be originated, agreements negotiated, and creditworthiness established – basically all the activities that banks used to do (and to some extent still do) before stricter regulations, capital requirements, etc., created a vacuum. In lending. The special credit bonus is simply compensation for doing all that work – the “economic rent” in economic jargon.

Hanig points out that the premium is larger for small loans. For the half-billion-dollar loans where companies like Apollo, Ares and KKR are bidding, he doubts whether there are excess returns to be had.

C Shawn Booking agrees that private trusts

Get higher spreads and total returns because they offer speed and certainty of execution and lower cost of capital; Privacy in that the borrower does not need to become a general advancer; The ability to [do] Deep diligence and financing complex situations that are not suitable for common vanilla public markets, light diligence; Structuring creativity; An ongoing funding partnership means sponsors and management teams can quickly and easily leverage follow-on funding. . . An effective insurance policy in a negative scenario where the sponsor/borrower can conduct rational and constructive negotiations. . . Without losing their company to a flock of naughty cats in the form of distressed investors

Paul O'Brien put the friction firmly on Banks' side:

Bank credit is artificially expensive due to regulations such as capital and leverage rules. We do this to reduce risks on the deposit base. Thus, when bank lending dominates credit markets, unregulated private capital may be able to achieve excess returns.

But he points out that the free lunch will be taken:

This does not have to be a permanent situation. As we see now, more private capital will flow in, banks will retreat, and excess returns will disappear. Maybe they have [already].

Recall that the authors of the recent paper arguing that private credit investors do not receive any return beyond risk – Issel Erel, Thomas Flanagan, and Michael Weisbach – agree that this form of economic rent exists, but at the aggregate industry level it is eaten up by fees:

Return that [private credit] Borrowers pay more than the risk-adjusted interest rate, which is roughly equivalent to the fees charged by private debt funds. The rents that funds earn from making direct private loans go to the general partners, not the limited partners. They appear to reflect compensation for identifying, negotiating, and monitoring private loans for companies that could not otherwise raise financing.

It seems, then, that most people agree on the source of the excess return. The debate is whether it will continue as the industry attracts more capital, and whether it exceeds the fund's fees. Here's Hanig again, taking the other side of Errell, Flanagan, and Weissbach's argument:

A final open question is whether private credit managers are keeping the economic rent for themselves through high fees. I can tell you from first-hand experience that they (especially at the small cap end) take their pound of flesh, but there is plenty left over for investors.

One good read

A defense of the theory that more abortion means less crime.

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