Far from the bustle of Wall Street, inside his downtown Minneapolis office, Tim Magnusson got his first aching gut feelingabout U.S. inflation in May of last year.
That’s when U.S. government data showed a 10% increase in used car and truck prices during the prior month, April of 2021. Magnusson, then a senior portfolio manager at hedge fund firm Garda Capital Partners, sensed something was amiss from the report. Magnusson had spent more than a decade of his careeras an inflation traderand his father was a truck driver. He had never seen anything like it.
In fact, the 10% gain in used car and truck prices was the largest one-month increase in almost 70 years of record-keeping. It was accompanied by rising costs for shelter, airfares, recreation, motor-vehicle insurance and household furnishings — all of which contributed to the consumer-price index surging to a 4.2% headline rate, the highest year-over-year rise since 2008, up from 2.6% in the prior month. And even the month-over-month reading, at 0.8%, was a huge upside miss to economists’ expectations for a 0.2% gain.
Before the April 2021 report, Magnusson had been firmly in the lower-for-longer inflation camp. But he suddenly shifted his thinking and concluded the U.S. was about to break away from three decades of low inflation, a view not publicly shared by many in financial markets or professional forecasters at the time. Since then, year-over-year inflation has only worsened and shown no conclusive sign of peaking. And it will “almost assuredly” end 2022 above 7%, a levelthat “screams failure by the Fed,” Magnusson told MarketWatch. That’s because CPI also ended at 7% in 2021. Breaching that level a full year later would suggest rate hikes by the Federal Reserve haven’t been enough, while dashing hopes the U.S. has hit the peak of price gains, he said.
The past year has proven that Magnusson — currently chief investment officer of the now-relocated Wayzata, Minnesota-based Garda, which oversees more than $8 billion for institutional investors — has had his finger on the pulse better than most. As of March 31, Garda’s Fixed Income Relative Value Opportunity Funds had a 4.1% return in the first quarter, according to London-based data provider Preqin. This was at a time when U.S. government bonds were having one of their worst quarters since the Civil War. Garda’s funds also produced a 2.7% return over the 12-month period that ended on March 31 and an 11.7% three-year annualized return, besting the Bloomberg U.S. Aggregate BondIndex. Garda’s first-quarter performance also beat the performance of five out of six hedge funds with fixed-income arbitrage strategies, as tracked by HSBC’s Alternative Investment Group. Meanwhile, well-known economists like Janet Yellen have since acknowledged they were wrong about the path of inflation.
“We try to be in the moment to understand what’s going on,” Magnusson, 50,said in a phone interview.
“It didn’t take a genius to see prices would go up. That was corroborated by what we were seeing with our own eyes” last April and May, he said. “Used-car prices were going up in the publicly available auction data and you could get into a car, drive around, and see car lots and dealer lots that were empty,” said Magnusson, who grew up in Michigan’s remote Upper Peninsula. “We could also see Zillow rent data and rent contract prices. When you peeled back one layer of the onion, you could see something different: Something was out of bounds.”
CPI at almost 9%?
Garda’s inflation investment strategies primarily focus on CPI swaps, the TIPS market, CPI fixings, and their equivalents in other currencies. It’s in fixings where traders appear to be the most downbeat about inflation’s prospects: They foresee annual CPI readings from May through September of 8.5% and above — a view Magnusson says will prove to be “more or less correct” or possibly higher.
Fixings, or derivatives-like instruments related to Treasury inflation-protected securities, were trading at levels this week that imply Friday’s annual CPI rate for May will come in at 8.5% — above the 8.2% expectation of economists polled by The Wall Street Journal and matching the 40-year high hit in March. From there, the CPI rate is seen as rising to 8.8% in August and September before settling at 8% in October.
If those expectations play out, they would most likely come as a shock to most investors, who are counting on inflation to fade: Stocks have occasionally rallied in recent days on the view that Friday’s CPI release for May may show easing price pressures relative to April’s 8.3% and March’s 8.5% readings. Some have pointed to falling prices on everything from semiconductors and shipping containers to fertilizer as reasons for optimism.
“”Most people in the inflation space have no imagination … We try to think about the extremes and where they could go.””
— Tim Magnusson, chief investment officer of Garda Capital Partners
But the U.S. has already been through a full year of false hopes on inflation. Last May, many chalked upthe April 2021 surge in prices to temporary distortions created by the pandemic, and clung to the idea that it would prove to be transitory. The universe of professional forecasters more or less stayed sanguine about the prospects of elevated inflation. Big-name firms from Goldman Sachs Group Inc.
to bond titan Pacific Investment Management Co. laid out benign-inflation outlooks. And Federal Reserve policy makers kept interest rates near zero — pushing the Nasdaq Composite
to a record close on Nov. 19, while Dow industrials
and the S&P 500
saw record one-year point gains on Dec. 31.
No growing sense of concern became broadly apparent until Nov. 30, when Federal Reserve Chairman Jerome Powell said “it’s probably a good time to retire” the word “transitory” from the inflation vocabulary. Meanwhile, professional forecasters surveyed by the Philadelphia Fed slowly began marking up their forecasts, while investors clung to mean-reversion theories that suggested inflation would eventually return to its historical pattern.
“Overall, a lot of people missed the spike in inflation because there were a lot of crosscurrents that made it so different than prior cycles,” said Mike Skordeles, an Atlanta-based senior U.S. macro strategist at Truist Advisory Services. “We had a broad-based supply shock and a demand shock, and we’ve never had that sort of simultaneous demand spike and supply shock happen at the same time in modern economics.”
Still, Skordeles said, inflation pressures appear to be abating and one year of high readings “doesn’t make a trend.” The strategist said “it’s way too early to call” whether inflation has entered a new regime. And he takes issue with the idea that anyone could have predicted all the factors that would keep inflation high — which include the U.S. economy’s strongest full year of growth since 1984 as of last year, pandemic-driven housing demand, and the exogenous shock from Russia’s war on Ukraine. Even if inflation remains elevated for years, he said, “the consensus view is that after we get past these next few years, we’re going back to a long-term trend of 2%.”
The Philadelphia Fed’s professional-forecasters survey underscores those sanguine expectations: As of May, 34 forecasters expected headline CPI to drop to a median estimate of 3.7% for the fourth quarter. Over the longer term, they saw inflation averaging at a 2.8% annual rate over the next 10 years.
But many have already been completely wrong about where inflation would end up in 2022: Early this year, 36 forecasters expected CPI inflation to average 5.5% for the first quarter, 3.8% in the second, and 2.7% each for the third and fourth. Instead, inflation shocked nearly everyone, shooting up dramatically by 7.5% in January and staying near 8% or higher every month since.
“You had to use your imagination,” Magnusson said. “Most people in the inflation space have no imagination: Traders, people who make markets, professional forecasters: Virtually all of them were wrong, not because they were using spreadsheets and models, but because they didn’t look around. And all those models broke. We try to think about the extremes and where they could go.”
What makes Magnusson’s view about the likelihood of inflation ending the year above 7% especially pertinent is that at least one top U.S. policy maker, Lael Brainard, has said she’s looking for a string of decelerating readings to gain greater confidence that the Fed can eventually hit its 2% target. But inflation is proving more durable at a time when the central bank is in the process of delivering a series of aggressive half-percentage point rate hikes, while shrinking its $8.9 trillion balance sheet.
“I sit here at my desk and talk to my analysts and ask, ‘What are they at the Fed basing this on?’ Some day they may be right, but not this year,” Magnusson said. “We’re now well into Year Two of high single-digit inflation. At some point, inflation will roll over. But I don’t think anyone in the market — the stock market, the fixed-income market, in the U.S. in particular — really appreciated how inflation would dictate returns on every asset price. If you didn’t get inflation right in the past year or so, you didn’t get anything else right in your portfolio.”
In his mind, policy makers will likely need to raise the fed funds rate to 4% or higher by 2023, versus the market’s current estimate of 3.25% next June, up from a current level between 0.75% and 1%. Moreover, Fed officials will “probably go as high as they need to go to kill inflation,” he said. “I think they will be successful in the end, but I don’t know how far they’ll have to raise rates to get there.”
“I don’t know for sure, and no one knows for sure, where inflation will end up after the next several months,” Magnusson said. “But we have not tried to call a peak to inflation, either internally or to investors. We’re going to know there’s a peak when we look back on three or four months of data. “
“Inflation is the most important thing in everyone’s life right now, in the U.S. and other countries,” he said. “We have to get this right or else the consequence will be felt far and wide. It’s not just about financial markets and hedge funds making money: It’s about one of the most respected institutions in the world, the Fed, doing its job and getting it right.”