Newsletter

The Fed and Treasury are doing little to assuage concerns about inflation, that the Fed’s new stance
on limiting “forward guidance” or Treasury’s increased bond buying on the long end of the curve will be
good for the economy and markets. In particular, we see both institutions’ recent actions as harmful
to bond market participants’ views on the long-term inflation situation and called into question the
credibility of institutional stewardship in the United States. This is an important matter to continue to
monitor, as the dollar’s status as the world’s reserve currency allows us to sell more debt than we
might be capable of doing otherwise. If that status is reduced, we may see fallout from weakened
ability to both sell and service the national debt.

The latest readings for CPI showed a reversal of the prior period’s slight decline. The headline number
came in at 3.4% year over year and 0.1% month over month. The month over month figure included a
period of relative calm in the Persian Gulf that is not applicable as the cadence of attacks traded
between the US and Iran has increased. Oil is trading at $96, and it appears likely that the risk
continues to be to the upside here.

Stocks are relatively rangebound, with the S&P 500 trading back near its all-time highs in a roughly 3%
range, and this is despite technology stocks (chipmakers in particular) being well off theirs (~18%
lower). With commodities rising, hostilities flaring in both Europe and the Persian Gulf, the statistical
association between volatility and this time of year, we continue to see elevated risk of a volatile period
coming. One stock valuation metric we use suggests that the equity risk premium (which is the
compensation investors get for taking the risk of stocks versus investing in risk-free bonds) is only 7.2
bps, essentially zero. With the measure having more typically averaged 200 – 400 bps over most of the
past 80 years, stocks are appearing historically expensive. Put into plain English, there is little
incentive in the marketplace to buy stocks at current prices. Until earnings expectations rise and
inflation is brought under control, or the market reprices lower, this condition will likely persist.

Treasury bond yields continue to rise despite the efforts of the Treasury Secretary to control the longer
end of the curve or the pronouncements that all is well from the Federal Reserve. Bond investors price
the inflation risk premium into their loans to the government, as it is the only effective risk in US
Treasuries. Bond yields are an extremely accurate view of how bond investors are thinking about
inflation, particularly at the 10-year and out points on the curve. High-quality corporate bond yields
remain among the most attractive in the past 20 years.