One key difference from the European experience is that U.S. labor participation simply hasn’t recovered to pre-pandemic levels.   

While “planning to raise compensation” is not the same as actually raising it, we all know that inflationary expectations build their own pressures and, once compensation starts increasing, those expectations become reality. Nordea published an interesting chart that gives an indication of the inflationary pressures already built into the wage structure in the U.S.  

Euro inflation is not driven by supply chain issues, or wage pressures or lack of workers. Those are certainly putting some inflationary pressure on prices, but, in the Eurozone, inflation is largely about energy prices. There are some crucial supply issues that Europe faces, whether because of low Russian gas supplies or a transition away from fossil fuels. This issue is more than one of inflation, however. This is an issue that has repercussions across all sectors of the Eurozone from how people heat their homes this winter to how business can operate with supply shortages. Our view is that Europe will find ways to provide adequate supplies and deal with shortages. We believe that the ECB will not view interest rate increases as the answer to a more fundamental energy problem that is driving inflation numbers higher.  

Finally, our view is that the Eurozone’s bigger issue through 2022 will be maintaining growth where both energy supplies and energy prices are impacting consumers and businesses. In that environment, governments and central bankers will lean into a lower rate environment and provide more economic support.

*Please note: This content was written and released prior to Russia's invasion of Ukraine.

We have used it to indicate when recessions might arrive and, as you see, there’s no recession looming. However, let’s take a closer look. In prior periods where the U.S. came out of a recession (the blue shading), you can see that the yield curve typically widened out to about 300 basis points. Normal stuff. This time, it got to 150 basis points. Not normal stuff. 

We can all give reasons why this time was different (Fed bond buying, government stimulus, etc.), but it’s always said to be different and never really is. 

Consensus says inflation will be a problem throughout 2022, and the Fed will raise rates multiple times. (The first is expected in March 2022, followed by estimates of anywhere from four to six additional hikes throughout the rest of the calendar year.) Our spidey sense is warning us here, and here’s a scenario that strikes us at least equally likely: The Fed begins to raise interest rates, economic growth stalls, the yield curve inverts, or gets close to an inversion, and the Fed follows the ECB and the Peoples Bank of China and holds off further rate increases. Rates stay lower for longer in the U.S., just as they might globally. 

Does that sound terrible? An environment of low interest rates, okay economic growth and muddling through? It’s what we have had for a decade, and capital markets have done pretty well. That golden touch might stay golden a bit longer. 

Using Nordea’s analysis again, they estimate that 5%+ rental price increases are going to drive higher home/shelter prices in the U.S. If you factor wages, shelter and whatever is happening to food and basic services inflation (and we know one thing that's happening is that inflation hit a 40-year high in January), then the picture for the U.S. says interest rates will move higher, sooner, by more and for longer than the market is expecting today. That will make the U.S. a likely outlier compared to the rest of the world with higher inflation and higher interest rates. This will also likely mean pressure on public and private market valuations, particularly in the technology and growth side, as those tend to do worse in higher rate environments. It seems there can’t be any other realistic outcome. 

Do we believe the U.S. economy is, or will be, strong enough to withstand higher interest rates, particularly while the rest of the world is not increasing rates as rapidly? Is the economic recovery that strong, and is the debt situation that resilient? While we are looking at inflation as the major problem, and for good reasons, will more deflationary forces emerge during 2022 if interest rates are rising? 

You know we have relied on the yield curve to tell us what is likely to happen in the U.S. It has not let us down yet, so why stop using a tool that has been so accurate?