Inflation: 'The question is: Will it fall enough?' Morgan Stanley managing director

Michael Kushma, Global CIO of Fixed Income at Morgan Stanley Investment Management, joins Yahoo Finance Live to discuss how inflation has affected the market.

Video transcript

ALEXIS CHRISTOFOROUS: Want to stick with the markets now and dive a little deeper into that inflation report today with Michael Kushma, CIO of Global Fixed Income at Morgan Stanley Investment Management. So Michael, just your reaction to the inflation data we saw, which seems to be trending with everything we've been seeing over the past few months, that inflation is its highest in decades, and also what the impact is going to be on the Treasury market.

MICHAEL KUSHMA: Well, I'll answer the last question first. The impact has been very modest so far. Long-term Treasury yields have not really surpassed the levels we saw in March of last year. And 30-year end of the yield curve, the very back end of the yield curve, has traded even better than that, where yields are lower than they were at that point in time.

So the Treasury market in the longer maturities haven't been too affected by it. The shorter maturities have been majorly affected by it. And that's primarily because the Fed has made a pivot to adopting a much more hawkish, tighter monetary policy expected over 2022, 2023.

So when it comes to actual inflation, inflation is very broad-based right now. About six to seven months ago, it looked more concentrated in the COVID-related sectors. But goods prices have been rising at a very rapid rate. Housing prices have been rising at a very rapid rate.

Not surprising, we have an aggregate demand boom, given all the policy support which has been provided by the monetary and fiscal authorities in the US. And that's provided a huge kick to spending over the last year. I mean, goods demand in the United States is well over $500 billion over trend of previous years. And that has strained supply side channels, as well as causing higher goods prices.

So it's still ongoing. It should improve later this year, and should fall a lot. The Fed is expecting it to fall a lot. But the question is, will it fall enough?

ALEXIS CHRISTOFOROUS: You know, it is curious that the longer rates haven't moved more in reaction to the inflation data. That's a good point you bring up, Michael. And I know the bond market tends to be one or two steps ahead of the economy. So what do you think the action, especially amongst those longer yields, is telegraphing about how investors feel about inflation going forward? Are they confident that it's going to [INAUDIBLE] later in the year?

MICHAEL KUSHMA: So a very good question. I think everyone is comfortable with the idea that inflation will fall. The question, how far will it fall? The Fed and the consensus of market forecasters think it's going to be below 3% by the end of the year, and close to its target, call to 2%, 2.5%, at the end of 2023. That's a rather aggressive forecast, given the current trajectory, but not impossible.

And the back end of the yield curve is, I think, thinking of two different things, potentially. One is that it will achieve these much lower inflation numbers over the next two years, or secondly, it's quantitative easing. Is the size of the Fed balance sheet-- might want to call it financial repression-- suppressing risk premium on longer maturity yields, which has made those bonds look expensive, but justifiably expensive given the size of the Fed's balance sheet.

ALEXIS CHRISTOFOROUS: Do you think that we need to be worried at all about stagflation? You know, an environment of higher interest rates, but a slowing economy.

MICHAEL KUSHMA: Not-- well, it's going to happen in the sense that we will have a slowing economy this year. And last year, the US economy grew somewhere around 5.7%, I think, GDP over the course of the year. This year will be much lower than that it's going to be 3% to 4%, in that neighborhood, maybe with a two handle, depending on how Q1 ends up. And inflation will fall, unlike inflation rising. It was like a bit of a strange year of falling inflation but still very strong, above-trend growth.

And the issue, I think, in terms of stagflation right now-- and consumers are not behaving as if they also inspect an-- they expect an inflationary spiral, because if you really thought prices would continue to rise, you're probably better off buying it today, rather than waiting tomorrow. But everything we see is that high prices are deterring spending today.

ALEXIS CHRISTOFOROUS: You know, Michael, we know that mortgage rates, fixed mortgage rates are very closely tied to the 10-year, and not so much of those short-term Fed funds rates that are being affected or will be affected when the Fed starts to raise rates. What's your expectation for the mortgage market later in the year? Might we see this divergence and maybe mortgage rates don't move as high, even though we're going to be in an environment where the Fed is inching rates higher?

MICHAEL KUSHMA: It's a good question. This is certainly something which bedeviled the Fed back in the 2005, 2006 hiking cycle, where long-term interest rates did not move. Mortgage rates fell low. There was innovations on how mortgages were created and packaged, which led to a house price boom and bubble, which then we saw what happened after that, in 2008. This time around, we don't see any of those excesses, but the degree to that 10-year yields don't rise that much will support mortgages.

However, mortgages have two components, the Treasury rate, fixed-- the risk-free rate being the backbone of that, but there's also the prepayment risk in mortgage-backed securities. And the Fed is going to start unloading mortgages later this year, and will continue to unload them, such that they've said, over the long term, which is undefined, they intend to hold no mortgages. So if there's continuous mortgage-backed securities selling from the Fed, and maybe others in the marketplace, that could raise the spread on mortgage-backed securities relative to treasuries, which could push up mortgage rates even if Treasury yields don't move.

ALEXIS CHRISTOFOROUS: So many moving parts there. And finally, Michael, I know that you believe the biggest risk right now to the global economy is the Fed and other central banks getting inflation wrong. Tell us what that might look like.

MICHAEL KUSHMA: Well, there's a lot of uncertainty about inflation right now. Last year, everyone was very optimistic that inflation would fall, it was temporary, transitory, however you want to define it. It would naturally go away as the pandemic unwound and we moved to a more normal situation, which is, of course, proving more difficult to achieve. But anyway, the point is that everyone thought it would get lower and lower. But it hasn't. It's gone up and up and up, far surpassing what anyone thought was likely six to seven months ago.

So now central banks globally, not just the United States, are confronted with a challenge. Inflation is much higher than expected now, but it will go down. So the question is, how do I tailor my rate hiking process such that I bring help bring inflation down, but not tighten too much so that I go too far and cause, you know, a downturn in the economy?

So balancing of not raising rates too much, which would cause a recession or other downturns in economic activity, or not tightening enough so that inflation does not come down as much, which then risks much tighter monetary policy in '23 to bring inflation back down again. So it's this tightrope they're walking of not too much, not too little. And finding that right amount will be a challenge.

ALEXIS CHRISTOFOROUS: Yeah, balancing act for sure. Michael Kushma, CIO of Global Fixed Income there at Morgan Stanley, thanks so much.