Will a 2nd Stimulus Deal = Higher Inflation & Higher Rates?

• There will be ‘some’ kind of deal… it’s just when
• Keep an eye on bond and metal markets for inflation expectations
• Assessing the US 10-year Yield, Copper and Core PCE

Today was another “deal is off” day for the market. 

Democrat House Speaker Nancy Pelosi gave the Senate Republicans 48-hours to get a deal done before the election – otherwise it’s off. 

Markets lost a few points. 

Tomorrow it will probably be another “deal is on” day – and markets will catch a bid.

Who knows with Congress. 

My take:

Some kind of deal will get done… whether it’s this side of the election or the other. 

And if it’s happens to be before Nov 3rd – it’s likely to be a smaller deal (e.g., less than $2 Trillion) – which would be extremely helpful for small business and those unfortunate enough to be on the bread lines.  

However, if it’s other side (and assuming we get a “blue wave”) – then expect a more comprehensive deal to the tune of several trillion (e.g. $3T+) 

PNC Bank’s CEO Pleading for Stimulus

This week, PNC Bank’s CEO (a stock I like) Bill Demchak says he thinks a second round of stimulus is “absolutely needed” to better help consumers and businesses make it through the Coronavirus pandemic. 

We heard similar sentiment last month for other leading CEO’s (such as McDonald’s) 

Demchak said he is becoming increasingly concerned about consumer borrowers as well.

PNC is the seventh-largest bank in the U.S., with more than $460 billion in assets. When talking about when significant loan losses will begin to materialize, Demchak said on the company’s recent earnings call:  

•  “The consumer number in my view is going to be highly dependent on whether they provide more fiscal stimulus, which I think they absolutely need to do.”

And whilst I think it’s reasonable to price in ‘some form’ of relief money (within 1-4 months) …  there is an open question on what impact that will have – especially in terms of things like inflation and rates. 

For example, if we are to pump the spigots to the tune of another $2-$3 Trillion (incremental to the $2.2 trillion already spent) – does that increase the inflation risk (i.e., where there is more cash chasing too few goods)?

Let’s take a look at what will tell us well in advance… 

#1. US 10-Year Yield

Now as a preface, there are generally two groups of traders who are often right in the long-run – but they are typically early. 

The first group is the bond market (which I will assess in a moment with the 10-year yield). The second group are metal inventors.

With respect to bond prices (and their yields) – there are two things which cause for yields (and interest rates) to rise: 

• An improving economy; e.g., where investors feel more confident to rotate out of ultra-safe assets (bonds) into riskier assets like stocks (at a higher yield); and/or
• Probabilities of higher inflation; e.g., where the Fed could hike rates to cool things down

To be clear – today the bond market sees little chance of either in the near-term.

However, if Congress were to pass a substantial (e.g. $2+ Trillion) deal either side of the election – then it’s possible the bond market may start keeping a careful eye on possible inflation. 

Again, today the bond market sees very little risk of this – with the 10-year trading at just 77 basis points.  

US 10-Year Treasury Yields – Oct 19 2020

As we can see above – the 10-year yield has been ‘basing; around 50 to 80 basis points throughout the crisis. This tells me bond traders are: 

(a) not optimistic about growth; and/or
(b) see no near-term risk of sharply higher inflation

But if we look up close – we see yields inching higher. 

It’s not enough to worry the market – but it will be something to keep an eye on – especially as Congress paves the way for “trillions” in more public debt. 

#2. Copper Prices

Metals traders (via prices) are the other group I pay close attention to. 

Again, they are often right… but also early.

Specifically – I’m looking at what we see with the price of “Dr. Copper”. 

Copper is likely to reflect any ‘reflation’ in commodities as a result of either

(a) an improving economic outlook (i.e. greater demand); and/or
(b) expected inflation

Below is the weekly chart for copper futures 

Copper Futures – Oct 19 2020

Copper futures are now up over 50% since March – with the weekly trend bullish. 

And whilst we can expect some overhead resistance at around 3.40 (around 10% higher than today) – look for the metal to break through. 

So what’s the driver?

Well one explanation could be optimism for greater economic growth – especially with what we see in China. 

China, who consumes more industrial metals than the rest of the world combined, is using large amounts of stimulus to ‘once again’ start building more ghost cities and bridges to no-where. 

For example, data today showed China’s GDP expansion accelerated to 4.9% during Q3, up from 0.7% in the quarter to end-June

Metal intensive industries showed the strongest growth, with a further pick-up in industry and construction last quarter, from 4.7% year on year to 6%.

Another possible driver could be expectation of meaningful “shovel ready projects” from either US administration early next year. 

Both Biden and Trump are calling for further infrastructure projects (to help a stalling economy) which will increase the demand for copper. 

Finally, there’s always the possibility that more stimulus (and debt) will mean a lower US dollar. 

And with all commodities priced in US dollars – this will push up metals prices and from there – higher inflation.  

Note: as part of this post on October 10th – I suggested to traders to put Freeport McMoran (FCX) on your watch-list as a function of both gold and copper moving higher. 

Core PCE Inflation Remains Low

Before I close – it’s worth noting that PCE Core Inflation remains well below the Fed’s target of 2.0% to 2.5%

Core PCE Inflation at 1.59%

Core PCE is the Fed’s preferred measure of inflation.

And whilst we can debate all day about whether it’s the right measure (I don’t think it is – as there is inflation in the economy) – it doesn’t matter – as this is what the Fed will be targeting.

Now if this chart starts to edge above 2.0% over the coming quarters (as a function of the several trillions more in government spending and much lower supply of goods) – then it’s possible we will see the US 10-year yield rise.  

And it won’t take much….  

It’s important for readers to remember that rates will go higher and lower for two reasons: 

(a) the outlook for economic growth; and
(b) what we see with inflation

And inflation is driven by how much money is available relative to the supply of goods (I will share a good example in a moment). 

For example, in terms of money supply – government deficit spending could exceed $4 Trillion for 2020 or almost 20% of GDP (where GDP is forecast to be around $20T)

At the time of writing – today the deficit is $3.1 trillion – more than triple the deficit for fiscal year 2019 (and the largest deficit since WWII – which followed a depression)

Now on the supply side – think about the reduced number of goods available.

Supply chains have been decimated as a result of the virus (from phones to cars) – driving the prices of many goods sharply higher.

For example, the price of second hand ‘pickup trucks’ in the US have seen their biggest price increase since the 1960’s (due to severely constrained supply). Here’s CNBC today:

“In the space of two months, prices went from double-digit declines to double-digit gains, and have stayed high since June”. In August, KAR Global reported the average price for a full-size pickup hit a record high of $21,557. That’s up $5,166, or 31.5%, since February”

In summary, keep an eye on these charts. 
 
If inflation is on the horizon over the next year or two – then the market will start pricing in higher rates. 

And that could be a scary prospect for the market. 

Regards,
Adrian Tout