24 April 2023 Following the latest CPI and PPI data, it seems even more clear that inflation mostly peaked around June/July last year and has been easing since, particularly in the last six months. This note follows up on the comments I made back in December, highlighting the influence of shelter costs and the Fed’s […]
A key topic within the broader inflation debate is the influence of the biggest single component of the CPI: shelter. At about 33% of the current CPI weight, shelter (housing/rent) costs are clearly important, but measuring them is harder than it might seem.
The markets have remained focused on the Fed (and occasionally the Bank of England), and the Fed has kept its focus on the trailing reported inflation data (CPI, PCE, etc.) and on the labor market data (job growth, wages, etc.). The Fed’s view is that inflation cannot sustainably come down to a suitable level (2-3%) unless income growth slows down significantly. That is, income growth must decline to reduce excess demand. This certainly makes sense up to a point, but of course prices are determined by the combination of demand and supply.
Short-term movements in stocks, bonds, and currencies continue to be driven primarily by changes in investor perceptions about the Fed’s likely course of action over the next 6-12 months. In response to client questions, the following are some comments and charts reviewing recent history and the current backdrop.
The August CPI report released earlier this month was significantly worse than expected, and data since then has not changed the broader view of inflation for the Fed. Along with continued hawkish public commentary from Fed officials, this has driven a further rise in bond yields to new multi-decade highs, and cemented expectations for further aggressive rate hikes by the Fed.
However, despite the “hot” CPI reports, the level of expected inflation in five-year inflation swaps (the most direct way to bet on future inflation) has fallen to its lowest level in a year, and was recently trading around 2.6% (chart below), close to the Fed’s presumed target of about 2.5% on the CPI (dashed line). A similar picture is seen in the 10-year inflation swaps.
The stock market has rallied sharply since mid-July, while long-term bond yields have been stable to lower. Even the mighty US dollar has paused a bit in its uptrend. But inflation remains high (though likely peaking) and Fed officials continue to say they will continue to raise rates (and reduce the balance sheet) well into next year. The old market adage says “don’t fight the Fed” (i.e., be cautious when the Fed is tightening policy, and more aggressive when they are loosening), but it looks like markets have in fact been rallying in spite of the Fed lately.
Yesterday’s decision by the Federal Reserve to raise rates by 75 basis points for a second consecutive time was historic, as it marks the most aggressive back-to-back rate hikes (150 basis points in less than two months) since the early 1980s, before the Fed was formally targeting the fed funds rate as its key policy focus.
The Fed’s statement and press conference yesterday clearly indicated that the Fed is not done with raising rates yet, but gave some of the first indications that they are acknowledging the signs of slowing economic growth and that the lagged effects of the rate hikes to date have not been fully felt yet. Markets reacted favorably to the news (75bps was well anticipated before the meeting), as it brings the potential for smaller rate hikes and the eventual end of the rate hike cycle closer.
Markets remain volatile, but the narrative driving the volatility has been shifting recently, a topic we have written about and discussed with clients recently. For much of the year, the concern was that the economy was “too strong” and inflation was out of control, and thus the Fed would need to raise rates and reduce their balance sheet quite aggressively to combat inflation. The Fed has taken several steps in that direction, but now conditions have changed such that investors are more worried about growth slowing too quickly and turning into a recession rather than excessive inflation.
Yesterday’s Fed policy announcement was certainly the focus of attention, and monetary policy has been driving headlines and market action for much of the year. However, our view is that fiscal policy is likely the bigger policy force in the economy nowadays, and fiscal tightening started some time ago.
While all markets have been volatile recently, the normally “safe” Treasury bond market has been especially volatile, and is giving mixed signals. This means that even in a generally “risk off” backdrop, the normally riskier stock market (S&P 500) has outperformed long-term Treasury bonds by a historically wide margin over the last month.
The US bond market has had a rough time lately. The ICE/BofA Long-Term (10 year+) Treasury Total Return index (i.e., which includes coupon payments and price changes) has fallen 16% from its latest November 2021 peak, and is down 23% from its latest cycle peak in July 2020 (excluding the spike in March 2020). Thus bonds are clearly in a bear market by the unscientific “down 20% or more” rule of thumb. And from a volatility standpoint, bonds are at more extreme readings relative to their normal range than stocks are, based on the VIX (S&P 500 implied volatility) and the MOVE index (Treasury bond implied volatility).