High yields are ‘indicative of a world where inflation is staying high’: Strategist

Michael Kushma, Morgan Stanley Investment Management CIO of Broad Markets Fixed Income, sits down with Yahoo Finance Live to discuss the economic outlook on the Fed's interest rate hikes, inflation, jobs data, and oil and gas prices.

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- It's nice to see you, Michael, and happy Monday. Jared touched on the 10-year rising to 3% earlier, highest since May 18. What do you make of it?

MICHAEL KUSHMA: I think we're returning to a more reasonable level given the length of-- strength of inflation we're seeing in the global economy, in oil prices, food prices, et cetera. The big rally we had last month from the peak of-- I think we had about 3.15% at the beginning of May and then rallied for the rest of the month on the back of equity market weakness and fears that the economy would move into recession and the fed would pull back on rate hikes.

So that rate cut-- not rate. The reduction in rate hikes expected by the market in May is sort of being taken out again and yields are pushing back up to the highs we saw in May, and particularly the five-year and two-year are getting back to the same levels previously. So I think it's indicative of a world where inflation is staying high and oil prices are not consolidating or coming down at all.

- Michael, what does this mean for a fed policy, because largely, expectations for 50 basis-point hikes in the next two meetings? Looking out to September, though, what do you see the Fed potentially doing?

MICHAEL KUSHMA: Well, I think everyone agrees that the next couple of meetings, the next 100 basis points in June, July, 50 basis points each meeting is sort of baked in the cake. It will happen for sure. After that call it in the fall, September, October, I think it depends on where inflation's going to be.

It looks like the markets, the economy, is going to hit the fed's end of year inflation targets, which is still above their long-term targets. They can slow down the pace of tightening. The fed has been quite keen to get to nominal interest rates, which is somewhere between 2% and 3%, they've said, probably at the higher end of that range 250, 275. But if things are getting better, it doesn't have to be great but getting better, they'll slow down the pace of tightening into year end. But if they don't, we can possibly likely see a 50-basis point rate hike in September as well.

- Now, what about the fed being impacted by some of these other events that it can't control? Obviously, you have COVID supply chain disruptions and obviously geopolitical events. How much pressure does that add in what the fed plans on doing?

MICHAEL KUSHMA: It is certainly pressure, but the underlying fundamentals of the economy are very strong. The labor market employment growth is robust. We just saw a 300,000-plus growth number last month, participation rate up. Wages are growing very strongly. If you take into account hours worked plus employment growth, we're talking about 9% household income growth, which is well above the levels you'd think about normal, with normal inflation, down the road.

So irrespective of the supply shocks, which are exacerbating the problem, the underlying momentum, particularly in labor markets, is strong enough to keep the fed strongly attuned to what's going on and keeping raising rates despite the risks which come from oil prices and food prices.

- Michael, how pivotal is that inflation print we'll get later this week, and what do you expect from it? Do you expect we'll see that it's beginning to come down?

MICHAEL KUSHMA: Well, it should be coming up. The month-on-month numbers should be getting better. Even last month we saw it come from 8.5 to 8.3, the annual numbers. It should come down a bit more. I think that's pretty much going to happen for sure. But the pace of increases needs to slow down a lot.

So if the remainder of the year, if the CPI number slows to a monthly number of like 0.3%, which is sort of an annualized 3 and 1/2%, 4% rate, that's probably OK in terms of where we're going to be by the end of the year. If, however, we stay in a 0.4%, 0.5% monthly or higher, that will show no real underlying trend improvement and keep the fed particularly watchful as to what's going to be happening in the end of the year.

- Michael, is the market having a tough time figuring out the pattern when it comes to these economic data points? Because just looking at the labor market last week, we got a strong print on Friday yet we got a very weak private payroll number, that ADP report we got on Wednesday. How does this factor then into maybe some of the volatility that we could expect to see as we do see this mismatch between the economic data?

MICHAEL KUSHMA: We know there's a lot of to and fro between the supply side of the economy, the demand side of the economy, between the goods sector and the service sector in terms of what's going on. We've seen layoff announcements in the tech sector. We've seen, however, boom conditions in the airline industry. If anyone's been traveling lately, it's challenging. There's crew shortages. There's airplane shortages. There's shortages of rental cars. On the shortage of people working at various places it's still a challenge.

So from that perspective, and particularly the JOLTS surveys, the job openings are still at absolute record highs. Coming off the top it may be true that the labor market has peaked in terms of tightness, but the pace at which it slows is likely right now to be pretty slow and keep the fed particularly hawkish going into year end.

- I want to talk about the fixed income market there. In terms of the signals that you're watching for, in terms of what you should be rotating into or out of, what are you keeping an eye on?

MICHAEL KUSHMA: Well, it's the strength of the economy and particularly the inflation rate and how comfortable the central bank is, the fed in the United States and, obviously, other central banks around the world, how comfortable they are with the pace of declines in inflation. I think everyone is forecasting inflation is going to come down. The question is how fast? How long is it going to take to get to appropriate levels?

If the fed decides that it can wait two years, till the end of sometime in '24 before it gets to its target, it can achieve a soft landing. Doesn't have to cause a recession to hit that inflation target. If however it sees chances or risks that inflation is going to get more embedded in the economy, making it really hard to get to that inflation target, call it the end of '23 and '24, then it needs to slow the economy down faster to achieve those numbers.

So it's all about the pace at which inflation falls over the next several months, assuming, of course, that oil prices don't go to $150 a barrel, and food prices don't keep escalating, and the supply side keeps getting more challenged. But the reopening of, potentially, the Chinese economy in the second half of the year I think is bullish for commodity prices, also suggesting that it's going to be hard to get headline inflation down meaningfully to levels central banks are comfortable with.

- You say unless we see $150 barrel of oil. Are we likely to see that, though, by the end of the summer, given the price of gas rose $0.25 in a week and $0.52 in a month?

MICHAEL KUSHMA: I'm not an expert on the oil market and supply demand conditions, refining capacity, and all those industry dynamics which go into setting the price, but we do know prices tend to rise in the summer. People drive more, go on vacation holidays, airplanes, cars, buses, trains, et cetera. So it's difficult to see on the demand side, demand falling a lot despite the rising-- how high prices are.

So high prices do restrict demand. We are seeing signs that demand for oil is falling. But total expenditure on oil is staying high. And that means that right now it looks like there is still upward pressure on energy prices in general. How high they go, I don't know.

- I do thank-- so it's anyone's guess at this point. We do thank you so much. Michael Kushma there, Morgan Stanley's Investment Management CIO of Broad Markets Fixed Income, thank you so much.