About this episode:
The Consumer Price Index (CPI) has risen to its highest level in over a decade, but long-term interest rates have continued to decline. In the latest episode of FireSide, Director, Investment Research, Kara O’Halloran is joined by Chief U.S. Economist, Lara Rhame, to break down this perplexing phenomenon.
Kara O’Halloran (00:05):
Welcome back to FireSide, a podcast from FS Investments. My name is Kara O’Halloran. I’m a director Director on our Investment Research team here, and I am once again, joined by Lara Rhame. Our Chief U.S. Economist, Lara. Welcome.
Lara Rhame (00:17):
Hey, thank you. This is going to be a good one.
Kara O’Halloran (00:19):
I think so, too. It’s a hot topic. So we are back again to talk about inflation and more importantly, the big question out there, which is why inflation is rising and bond yields are falling. So we did an entire episode on inflation a few months ago, and we said that that would not be the last time that we were talking about inflation in 2021. And we were spot on because here we are. And on that episode, which keep in mind, we recorded before both the May and June CPI readings. We talked about how we did expect inflation to rise largely due to base effects as prices had really plummeted last year.
Kara O’Halloran (00:55):
But we also talked about some of the supply constraints and pent-up demand that could cause pricing pressures. And now, lo and behold, here we are. We had a CPI reading in both May and June north of 5%, which were the largest increases in over a decade. But another thing, Lara, that you said then is ignore, ignore, ignore.
Lara Rhame (01:15):
Kara O’Halloran (01:15):
And we’ve seen that happen. At least I should say markets have not really reacted. We, as investors, are certainly paying close attention to inflation. Actually, I think the market reaction has been a little bit surprising because as I said, interest rates are declining.
Lara Rhame (01:31):
Kara O’Halloran (01:32):
The yield on the 10 Year Treasury has fallen in recent weeks. At one point dipping below 120 basis points. So Lara, the million-dollar question is, : why are bond yields falling while inflation is rising?
Lara Rhame (01:45):
Kara O’Halloran (01:46):
Lara Rhame (01:47):
Let’s tackle this right off the top. It’s important to really, I think on the interest rate side, realize that, historically we’ve had a more clear-cut driver of interest rates. And one of the big pieces of that is inflation. A lot of us remember—maybe not you Kara,—but me, my parents, a lot of the Baby Boomer generation,
Kara O’Halloran (02:15):
I’ve read about it.
Lara Rhame (02:15):
Yeah. Remember the inflationary period of the ‘70s and ‘80s and interest rates certainly were rising in lockstep with those higher inflation rates. So, inflation is absolutely a part of the broad interest rate narrative, but the driver of interest rates right now has really changed. We’ve seen, structurally outside of inflationary trends over the past several decades, we’ve seen interest rates fall. That’s been something we’ve all been experiencing as investors, as home buyers. We’ve all seen interest rates on this multi-decade decline.
Lara Rhame (02:58):
And it’s left us with global yields that are in many cases, negative especially for developed markets. That really puts pressure on U.S. interest rates to fall. And then, of course, the pandemic. Really and this started in the Global Financial Crisis. We’ve seen fed Fed policy pivoting to explicitly pushing down long-term interest rates as a way to help support the economy. So, right now, I think it’s wrong to say that markets are totally ignoring inflation. It’s just that all of these other factors are really overwhelming any concern about inflation because policy, structurally, and globally we are experiencing low-interest rates.