Lower Growth + High Inflation = Stagflation

Another round of solid inflation numbers has just been released. Core PCE month over month aligned with the consensus forecast of 0.3%, while the year-over-year increased to 2.8% versus the consensus forecast of 2.6%.?

Inflation is not trending in the direction that the Fed expects. Personal spending increased by 0.8%, which is far too much to restrain aggregate demand.

As my esteemed followers are aware, I have been consistently highlighting since December that the bond rally post the December Fed Pivot would be short-lived. This was proven when the 10-Year Yield, a key indicator, hit its low at 3.79% on December 27th, and then began its ascent as the market awakened to the reality of inflation being more persistent than anticipated.

The 10-year Yield surpassed 4.5% last week not only because inflation has been stickier than expected but also because several other forces out of the control of the Fed are at play; some of them are:

1. Not-Aligned-With-The-West Countries have considerably reduced their investment in US Treasuries and diverted to Gold, which they will not store in London or New York in the future. They will store the Gold in their own countries to reduce the risk of confiscation.
2. The US's fiscal policy, which can be described as nothing short of reckless, has propelled our debt level beyond 34 Trillion USD, with no discernible plan to reverse this alarming trend. This has led to investors demanding?a?higher term premium to safeguard themselves against potential future inflation.?
3. The US real interest rate is hovering around 2%, which many think is high, and it should revert to zero soon. However, the market has historically punished countries that run high fiscal deficits via higher real interest rates. I don't see investors softening on this front until Congress comes out with a clear plan to reduce the Deficit.
4. Our Deficit is at record highs during an economic expansion. Investors think the Deficit will explode when the economy hits a soft patch.

Looking at the technical analysis chart, there is no resistance until the 10-year Yield hits 5%, and I think we will get there unless the Fed publicly rules out any interest rate cut until data on inflation improve considerably or until the unemployment rate increases above 4.1%, which is the Fed threshold that marks optimum employment.

Many followers ask me how to navigate this period in their bond portfolios. There are indeed challenges, but there are also potential opportunities. Depending on the time horizon of each investor, there are strategies to consider. For those looking to park their cash for the next 12 months, money markets are a safe bet. For those with a longer time horizon, there are opportunities to increase the duration to six years. At the belly of the yield curve, IG Credit offers, on average,?a coupon of 5.5%, which is not far away from the historical long-term return of the S&P 500. Even Treasuries with Duration between five and seven years should be attractive now that the 10-year Yield is hovering around 4.7%. These are potential strategies to consider in the current economic environment.