Markets Now Recognize Approaching Disinflation
The CPI came in at +0.4% M/M for October, much better than the +0.6% consensus estimate, and the Y/Y number, a favorite of the Fed, fell to 7.7% from 8.2%. The financial markets rejoiced. The tech heavy indexes, which had been hit hardest in the markets’ recent selloffs, rose most. The Nasdaq rose 7.9% on Thursday; the S&P 500 was up 5.5%, and the DJIA, the least tech heavy, lagged, but still rose 3.7%. The “core” rate (ex-food and energy) only rose 0.3%.
While this CPI and the trends within it were unexpected for the markets, it wasn’t a surprise to us, as our view has consistently been that the markets have been too bearish on inflation’s future.
· Excluding shelter (+0.8%), energy (+1.8%) and food (+0.6%) (none of which are likely to repeat such readings in the near-term), the rest of the index actually fell -0.1%. There were price declines in:
- Medical care
- Financial services
- Auto rentals
- Delivery Services (which says something about the state of the consumer)
- Used Cars
· In past blogs, we’ve talked about the antiquated way the Commerce Department calculates rents. The rise in rents in this CPI report was the highest since August 1990. We know that in the private market rents have been falling and we know that these will show up in next year’s CPI releases thereby exerting downward pressure on the index.
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· Energy and food prices are already high; if they simply stopped rising, the Y/Y CPI, which apparently is driving the Fed, would fall to 1% by June. The table shows where Y/Y CPI would be with monthly growth rates of 0.0%, 0.1%, 0.2%, and 0.3%.
· There is the possibility that we have some months of negative CPI growth. That will occur if food, energy, and rent prices simply stabilize. Let’s be conservative and use the 0.2% column. By June, the backward-looking Y/Y measure of CPI that the media uses would be 2.6% and it is likely that we will be in a deep Recession. By then, it seems pretty evident that the Fed will have to start dropping interest rates.
· At this writing, it appears the Fed will deliver a 50-basis point (bps) rate hike at its December meeting. However, there is still one more employment report and one more CPI report before that meeting. A weak employment report and another good November CPI may even convince them to only raise 25 bps; and maybe that will be it for this tightening cycle.
· It looks like the fixed-income markets are beginning to anticipate this, as, on Thursday, the 2-Yr T-Note yield fell -30 basis points (bps)(i.e., -.3 pct. points), the 5-Yr fell -35 bps, the 10-Yr fell -33 bps, and the 30-Yr fell -26 bps. (Hope everyone bought Treasuries on Wednesday!)
One of the hallmarks of tightening cycles is that it exposes the over-leverage that often builds up when, prior to the tightening, the central banks have been easy for far too long. It is well recognized that in this cycle the Fed and other major central banks stayed way too easy (near 0% interest rates) for way too long. To top it all off, this particular tightening cycle has been the swiftest since the Volcker era (early 1980s)(see chart at the top). During these periods, various instabilities appear. The classic examples of this are the Long-Term Capital Management (1998), and Lehmann Brothers (2008) bankruptcies. There have been others: Orange County (1994), and Penn Central (1970; nearly taking out Goldman Sachs) come to mind. Nearly all of these occurred as interest rates rose, exposing those who over-leveraged.
In today’s world, we’ve recently seen the Bank of England come to the rescue of U.K. Pension Plans who were over-leveraged due to skinny yields for so many years, and we have seen other central banks use a significant portion of their reserves to support their currencies (Bank of England, Bank of Japan, Peoples Bank of China, European Central Bank…).
This past week, the cryptocurrency market cratered as a major crypto platform, FTX, suffered the equivalent of a bank run, and filed for bankruptcy. Its CEO and founder, Sam Bankman-Fried, saw his $23 billion net worth all but disappear overnight. We also saw the Bank of Korea intervene in the foreign exchange (FX FX ) markets to protect the value of the Korean won. It added $36 billion of commercial paper and corporate bonds to its portfolio (Quantitative Easing) to stem the rise of interest rates there. All this is occurring because the U.S. Fed appears to have over-tightened and, worse, continues to tell the world that interest rates increases are still to come.
The Fed has more than 300 economists on staff, and these professionals produce many relevant studies. One of those reports is named the Financial Stability Report and is produced on a semi-annual basis. The latest report, just released, has a laundry list of concerns revolving around the financial stability topic. Among them:
- High vacancy rates in commercial real estate
- Margin calls due to rising interest rates
- Subprime consumer debt delinquencies
- Bond market liquidity
- Leverage in U.S. shadow-banks
- China’s property market
- U.S. consumer/business financial distress
This is no small list of concerns. Yet the Fed bosses seem indifferent despite the fact that these issues come from their own staff. We noted in past blogs that bond market liquidity was an issue as some large Treasury blocks could not be sold without breaking them up into smaller pieces. The mortgage-backed securities (MBS) market also has recently displayed some liquidity issues. The latter two may be partially due to the Fed balance sheet reduction ($100 billion/month of Treasury and MBS).
- There are other data points that concern us. The chart shows that banks are reporting significantly weaker demand for mortgages, a theme we have been discussing for several months. Also note that auto loans are weaker (and we note that used car prices have fallen four months in a row), and commercial loans have just turned negative. Not surprisingly, demand for credit cards has risen as consumers seek credit to maintain their living standards.
- We note that supply chain pressures have eased dramatically, and this is now showing up in the CPI. The first chart is one we showed in our last blog and is the poster child for supply-chain issues, i.e., the number of ships waiting to be unloaded at California ports. From a record high in February to a recent record low.
The second chart shows the cost to move goods across the pacific. Again, from a record high early in the year to near normal at the present time.
The third chart shows ISM manufacturing data (supplier delivery delays and prices), yet another indication that disinflation is in our immediate future.
Every indicator we watch tells us that the Recession has begun. These include the latest GDP and employment reports which we discussed in detail in our last two blogs. The Fed continues its hawkish rhetoric despite all the historical indicators (yield curve inversion, Leading Economic Indicators, internal Fed surveys) telling them that a Recession has likely already arrived. This Fed seems not to notice the havoc their policies have caused in the rest of the world (liquidity issues, currency values, etc.) and what the future consequences might be if that world decides that something other than the dollar should be the world’s reserve currency.
This past week, there was a run on a crypto exchange, causing that exchange to seek bankruptcy protection. As rates continue to rise, expect more things to break. All this despite the incontrovertible evidence that inflation’s back has already been broken. Too bad the Fed is looking at inflation through the rear-view mirror of Y/Y comparisons instead of looking at the most recent monthly data. Too bad they don’t parse the incoming data, like the GDP or the employment numbers to glean the real underlying trends.
In just a few short months, however, the incoming data will be so overwhelming (poor employment, poor economic growth, melting inflation) that they will have to “pause,” then “pivot.” We suspect that will be before mid-2023.
(Joshua Barone contributed to this blog)