Kathryn Cicoletti on Inflation and Interest Rates

August 28, 2022


The major­i­ty of this was in our LP let­ter. I added sev­er­al things that are not LP let­ter appro­pri­ate and more blog appro­pri­ate. Anoth­er thing I want to clar­i­fy is I’m writ­ing this as if I was pay­ing atten­tion to inter­est rates and infla­tion in the 70s and 80s. I wasn’t. My opin­ions are based on being born in 1977. My mom con­tin­ues to remind me that around the time I was born, 30-year mort­gage rates were over 10%, the Fed Funds rate was 20%, and infla­tion was around 12%. Today the 30-year mort­gage is around 6%, the Fed Funds rate is 2.25%, and infla­tion is 8.5%. I under­stand her point. I don’t argue with Boomers on infla­tion and inter­est rate trau­ma.

I am hap­py that Fed Chair­man Pow­ell final­ly admit­ted on Fri­day that house­holds and busi­ness­es need to buck­le up for a ride. Chair­man Pow­ell clar­i­fy­ing that we should in fact expect to see pain as a result of inter­est rate increas­es is real­ly the per­fect end to the sum­mer. We’ve spent boat loads of mon­ey on trav­el, used all our vaca­tion days, caught COVID, and we’re now con­fined (again) to order­ing gro­ceries from Instacart despite how many times the dri­ver can­cels the order because they got a bet­ter job. We’ve all been in pain the last three years and now we have more pain ahead? I would like to speak to pain’s man­ag­er. We don’t need more pain.

The yield on the two-year trea­sury has been high­er than the 10-year yield indi­cat­ing an invert­ed yield curve and a reces­sion.

U.S. GDP declined by ‑0.9% in Q2 after declin­ing ‑1.6% in Q1 indi­cat­ing we are in a reces­sion despite clar­i­ty from the NBER.

Major stock indices are down ~15% for the year through August and high-grade bond indices have lost ~10% YTD.

To add to the conun­drum, prices we pay for goods and ser­vices are sky­rock­et­ing, the con­sumer con­tin­ues to spend, yet eco­nom­ic growth is declin­ing, the labor par­tic­i­pa­tion rate is at its low­est lev­el in decades, and per­son­al loan delin­quen­cies are spik­ing!

Pow­ell just sig­naled the will Fed con­tin­ue to increase inter­est rates to tame infla­tion, even if the econ­o­my, pub­lic mar­kets, and pri­vate mar­kets are at stake in the short-term.

The good news is these con­flict­ing data points are not unfa­mil­iar to the Fed. The bad news is pri­or med­i­cine involved wran­gling infla­tion through aggres­sive inter­est rate increas­es, even if it choked the econ­o­my, which ulti­mate­ly led to a decrease in short-term rates to re-stim­u­late the econ­o­my and get back to equi­lib­ri­um. Read any arti­cle that came out on Fri­day after Pow­ell spoke in Jack­son Hole and you’ll see we’re in for a sim­i­lar roller coast­er ride over the next few years. This puts both pub­lic and pri­vate mar­kets in a very del­i­cate sit­u­a­tion.

Now on to some inputs….

Grain and wheat prices have sub­sided, freight costs are var­ied (vs. per­pet­u­al­ly spik­ing), and fer­til­iz­er prices, while still high, are on the decline. Ukraine recent­ly export­ed its first crop ship­ment fol­low­ing Rus­si­a’s inva­sion. As one of the world’s largest grain exporters, the increase in sup­ply helped push both corn and wheat prices down ~35% from their highs and back to their pre-war lev­els.

Ship­ping costs have cre­at­ed a big­ger chal­lenge for com­pa­nies as transpa­cif­ic freight costs are var­ied at best and still sig­nif­i­cant­ly ele­vat­ed at worst. The slow­er US econ­o­my helped reduce spot rates for 20-foot con­tain­ers to the US from Asia by about 33% through mid-June since peak­ing last Sep­tem­ber. How­ev­er, some trade lanes still cost more than 5X their five-year aver­age before the pan­dem­ic. One of the main goals of the recent Ocean Ship­ping Reform Act is to alle­vi­ate sup­ply-chain bot­tle­necks and relieve ele­vat­ed con­tain­er costs. In the end, Amer­i­can importers and exporters felt the law fell short on price con­trols and still leaves them behold­en to a con­sor­tium of over­seas ship­ping giants that con­trol the major­i­ty of capac­i­ty that moves trade glob­al­ly. While there has been some relief in food-relat­ed com­mod­i­ty prices and region-spe­cif­ic ship­ping costs, sup­ply-chain dis­rup­tions, sky­rock­et­ing ingre­di­ent costs, ris­ing inter­est rates, and a decline in GDP con­tin­ue to cre­ate a very chal­leng­ing macro sce­nario for all com­pa­nies.

What about exits? I bought the domain backthatspac.live in 2020. I’m still try­ing to get my twen­ty bucks back from Square­space. Exits have tanked as prof­itabil­i­ty con­tin­ues to be a top pri­or­i­ty for any acqui­si­tion, merg­er, or IPO. IPOs are down ~90% y‑o-y for the first half of the year lead­ing CEOs (Jamie Dimon) of the largest glob­al finan­cial insti­tu­tions to tell investors that an eco­nom­ic “hur­ri­cane” is on the way. Con­sumer-focused com­pa­nies have been fac­ing their own DTC hur­ri­cane as stay-at-home retail wanes off COVID highs and CACs spike. Com­pa­nies are re-fore­cast­ing bud­gets for a new CAC nor­mal and a par­tial shift back to in-store retail. This is a trend near­ly all DTC pri­vate com­pa­nies are adjust­ing for as “stay inside” stocks like Shopi­fy, Pelo­ton, and Zoom have been expe­ri­enc­ing earn­ings pres­sure all year. The Fed will con­tin­ue to exac­er­bate the sit­u­a­tion as high­er rates reduce val­u­a­tions of high growth com­pa­nies, which caus­es them to reduce spend, which can result in a slow­ing econ­o­my. Most com­pa­nies are focused on pre­serv­ing cash, cut­ting expens­es, and build­ing their foun­da­tion for prof­itabil­i­ty in 2023 and beyond.

Fight­ing infla­tion is the Fed’s num­ber one pri­or­i­ty. How high will they go before they start drop­ping rates again? I heard on the All in Pod that the num­ber is 5%. That’s 2x where we are now.

Find Kathryn on Sub­stack, and Twit­ter.

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