The most recent Consumer Price Index (CPI) report revealed that inflation ticked to 2.6 percent for the 12 months ending October 2024, up from 2.4 percent the previous year. Core inflation, which excludes the more volatile food and energy components, was unchanged from last month at 3.3 percent.
I waited with bated breath for each CPI report for the last couple of years. I have been feeling more “meh” about it for the last few months, but that may change. I am troubled by the five-year break-even rate, which is an estimate of expected inflation.
The math of this troubling statistic is the difference between the five-year conventional Treasury yield and the five-year TIPS rate, “TIPS” being the Treasury Inflation-Protected Securities. The break-even rate estimates what investors think inflation will average throughout the next five years. This is important because the Federal Reserve considers inflation expectations when setting interest rates.
The five-year break-even is about 2.4 percent, meaning investors expect inflation to average 2.4 percent over the next five years. That is up from 1.8 percent in September when Vice President Kamala Harris was at her peak in the polls and betting markets. Ever since the polls flattened out and betting markets started favoring now-President-elect Trump, however, inflation expectations have risen.
Investors are increasing their inflation expectations in anticipation of Trump’s pledged policies. This leads to the Federal Reserve setting interest rates. On November 14, 2024, Fed Chairman Jerome Powell spoke in Dallas, Texas. He reminded the nation that the Fed does not forecast fiscal policy in the calculus of setting monetary policy.
But hold up! The Fed also says it is data dependent. If investors are moving data based on their expectations, and those expectations are linked to fiscal policy, then the Fed is, in a not-so-indirect way, considering fiscal policy.
I expect the Fed to cut interest rates by one-quarter of a percentage point—or 25 basis points—at its December 18, 2024, meeting. I do not think they should, but they will. If you count “cuts” as 25-basis-point units, that will be its fourth cut. The Fed started with a 50-basis-point cut in September 2024 and a 25-basis-point cut in November. After a December rate cut, I do not have a high confidence level in the magnitude or pace of cuts for 2025.
If the five-year break-even rate did not spike, four more cuts in 2025 would have been my bet. However, now there is a better than one-in-three chance of two or fewer cuts by the end of 2025, according to the CME Group’s FedWatch Tool.
For bond investors, remember that central bank policy influences short-term interest rates more directly. The influence of inflation expectations is felt more by intermediate- and long-term rates.
If markets expect sustained high inflation, investors demand higher yields on bonds as you go further out in maturity on the rate curve to compensate for reduced purchasing power. This is primarily true for Treasuries and investment-grade bonds. High-yield or “junk” bonds tend to be influenced more by the potential of defaults.
In response to the rise in the break-even rate, I traded in some of my portfolios. I changed my asset allocation from intermediate-term Treasuries and investment-grade bonds to shorter-term bonds.
Another Trump Trade
Separately, I sold most of my healthcare positions and placed the proceeds in domestic small-capitalization stocks. Last week, I made a case for investing in small caps. I sold my healthcare positions because of what I consider a high-beta trade (a trade with two potential outcomes, each with opposite expected returns).
President-elect Trump nominated Robert F. Kennedy Jr. to head the Health and Human Services Department, the U.S. government’s principal agency for protecting Americans’ health. I am an exercise enthusiast and eat healthy, and I would love for the rest of the nation to join RFK and me in improving our fitness.
However, RFK has as much of a healthcare background as former Boeing CEO Dave Calhoun had in engineering, which is to say little-to-none. We have all seen how much Boeing struggled under Calhoun’s leadership up until his resignation. There is a high potential for error under RFK.
I root for all of America to get healthier, so I leave space for hope in RFK’s success. Still, I can envision plenty of downsides for healthcare stocks. I am not making a case for either a bad or good scenario, and that is the point: I would rather place my money in an asset class where I have a higher conviction, even if it means potentially losing out on some upside. (Full disclosure: My lack of conviction is bipartisan. I had doubts about Pete Buttigieg being appointed Secretary of Transportation, which went well. I like to invest where I believe I have an edge, and I do not have an edge in deciphering the ripple effects of this potential appointment.)
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
