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Inflation to stay fairly firm into year-end: Michael Kushma

Morgan Stanley Investment Management CIO of Global Fixed Income, Michael Kushma, joins Yahoo Finance to discuss inflation, the reaction to Chairman Powell’s comments, and how the market is adjusting ahead of the Jackson Hole Fed meeting.

Video transcript

MYLES UDLAND: The stock market set for gains at the open, but over the last couple of weeks, we have talked at length about what's been going on in the bond market. And of course, that remains in focus on the back of last week's Federal Reserve announcement. Joining us now to discuss is Michael Kushma, the CIO of Global Fixed Income at Morgan Stanley Investment Management. Michael, great to talk with you this morning.

So let's just start with how you guys thought about what we heard from Chair Powell last week, if it changed your view on where the Fed is likely to go and sort of how you are seeing, you know, the Treasury market over the balance of this year.

MICHAEL KUSHMA: Well, certainly, the Treasury market has surprised, I think, almost everyone in the second quarter in terms of its ability to rally despite good economic growth, exceptionally strong economic growth, and more hawkishness about the-- from the Fed, as well as surprisingly higher inflation as well. I think what the Fed did last week was confirm expectations that tapering is on the table.

We will continue to talk about it. It will happen at some point. You can't argue against that because the economy is doing so well. Despite worries about the delta variant and other issues, the economy is booming from all perspectives.

So the idea of tapering is on the table. It will occur. That was as we expected. However, they did continue to talk about not being sufficient progress on, particularly, labor markets.

And I think that's true. Labor markets have been disappointing relative to economic growth. We know there's lots of people still unemployed, and there's lots of jobs opening, but we can't match the two together. I think that's what the Fed wants to do.

And this relays-- makes the coming data flow very, very important, including this Friday's nonfarm payroll report, which will be the last employment report before the Kansas City Fed meeting. So if employment surprises the upside, we can talk about more confidence that the Fed will confirm that tapering is on the agenda and will occur at some point early next year.

MYLES UDLAND: You know, Michael, we heard from Powell last week talking about real yields. And he was asked, basically, what's the deal with Treasury yields having fallen, you know, 30, 40 basis points between the two meetings? And he said real yields, and then he sort of said, well, there's some other stuff we can't really explain.

How have you talked through the decline in yields we've seen with your clients? And what's kind of your team's thesis at this point on why we saw, you know, that move from around 175 basis points to, I guess, 115 at the lows?

MICHAEL KUSHMA: It's a good point. First, we have to understand whether or not the rising yields at the end of Q2 was actually real. Was that just another example of market liquidity? There was a lot of selling, not a lot of buying-- pushed yields artificially high. So maybe real yields got too high relative to the underlying trajectory that we would have expected otherwise, and we had some kind of normalization in Q2, which I think is a lot of story.

The other point is the world is awash in liquidity. The Fed is still buying $120 billion a month. Treasury issuance has fallen as they've run down their balances. The Treasury is [INAUDIBLE] their cash balances to the Fed.

The world is awash in liquidity. The ECB is buying up all the bonds-- corporate bonds and government bonds-- they can buy, basically, in Europe. So this idea that the market is flush with cash, banks are flush with cash, investors are flush with cash that needs a place to go-- anything is better than zero or negative in many countries. So that's just being pushed into bond markets, whether it's municipal bonds, US treasuries, high-quality assets are benefiting from the excess liquidity-- I wouldn't just call it excess liquidity, but the substantial amount of liquidity which exists in the world.

BRIAN SOZZI: Michael, how are clients positioned into the Jackson Hole meeting in a couple weeks?

MICHAEL KUSHMA: Well, until the last couple of months, basically, since mid-June, the market was short, expecting the Fed to taper, to announce, as they did in June, a faster pace of rate hikes. But despite all that, the market has reduced its expectations of where the Fed funds rate will terminate at some point down the road in that the Fed has talked about a 2 and 1/2% ceiling, or final terminal rate, to the Fed's run rate. The market now expects that to be well below 2, which is a fairly pessimistic view of the future.

So I think the market right now is getting much more optimistic, relative to the Fed, that yields will stay low, either because liquidity will stay strong, inflation will collapse, and/or the delta variant will continue to sort of wreak havoc with the economy-- or forecasts about the economy-- in the near term. So I think the market is fairly well balanced right now, and we could see higher yields if we get exceptionally strong data. However, if we get weaker data, the market's [INAUDIBLE] are likely to stay low or maybe even go a little bit lower still.

MYLES UDLAND: And then, on that inflation point, Michael, certainly, that PCE number that we got on Friday-- maybe, maybe the beginning of some sort of more firm transitory-type data? How are you thinking about inflation at this point?

MICHAEL KUSHMA: It's truly astonishing what's happened to inflation. People talk about how strong the real economy is. But nominal GDP, the actual monetary value of GDP in the second quarter, was growing, I think, at about a 16% annualized rate, which is extraordinarily high. And the real economy is only growing 6 and 1/2% in annualized rate because of supply-side bottlenecks.

So inflation is surged higher across the board because there's not been enough goods and services to buy given the income growth that people have experienced over the past 12 months and the wealth increases they've experienced in the housing market or the equity market. So we would expect inflation to stay fairly firm into year end until these supply-side bottlenecks are sort of out, which will take time.

MYLES UDLAND: All right, we'll leave it there. Michael Kushman, CIO of Global Fixed Income at Morgan Stanley Investment Management. Michael, always appreciate the time. Thanks for jumping on this morning.