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Friday's economic numbers were uniformly positive on both sides of the border and markets have good reason to celebrate. The terrific U.S. employment numbers are a clear sign that the U.S. Federal Reserve's monetary stimulus is driving the expected economic effects. But there is another side of that coin – Fed tightening – that is becoming increasingly likely by year end.
The most worrisome chart in terms of inflation expectations – a comparison of two-year U.S. Treasury yields and home building stocks – is this one. The enormous divergence is to some extent warranted because of the incredible damage endured by the housing sector during the financial crisis. The exorbitantly low rates were necessary to prevent a full collapse of the $15-trillion U.S. housing sector.
At some point though, the Fed will be forced to reign in the sector to avoid a return to pre-crisis excesses. The massive money printing operating since 2007 – the Fed's balance sheet has tripled since that time – has created an enormous supply of fuel that could ignite into an inflationary fire.
Admittedly, consumer prices have remained tame and are likely to remain so until employment and wage growth strengthen. But once inflation pressures become apparent, the excess liquidity implies that the Fed will need to pull back hard on the economy to stop inflation from spreading.
Again, none of this is imminent and investors should feel free to enjoy any rally that results from an improving U.S. economy. But they should also be prepared for more U.S. intense inflation chatter by the end of 2013. A rising rate environment would pose a major problem for investors in currently-favoured market sectors like REITs, utilities and high-yield bonds. The time to prepare is now – investors have enough time to create a strategy to deal with what will likely be a much different investment environment in 2014.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow