The Fed Plants A Flag On Peak Inflation and An Economic Soft Landing

Robert G. Valletta, associate director of research and senior VP at the SF Fed, planted a flag on peak inflation and an economic soft landing in a recent economic research blog post. Valetta provided data suggesting that inflation is finally on a sustained path lower alongside increased risks for a mild recession. The blog post is not an official statement from the Federal Reserve Board of Governors, but the work is a powerful message nonetheless.

Valetta declared “recent data suggest that inflation may have peaked.” The latest inflation projection shows a gradual decline toward the Fed’s 2% average goal around 2025 or 2026. Valetta cautions that “repeated upside surprises” to inflation mean that “the risks to this forecast [are] weighted to the upside.” In other words, we should expect the Federal Reserve to keep its interest rate higher for longer in order to ensure inflation’s glide path stays pointed downward. The graph below shows the recent peak and successive higher forecasts for inflation since March.

After on-going upside revisions, PCE core price inflation is now expected to approach the 2% target somewhere around 2025.

After on-going upside revisions, PCE core price inflation is now expected to approach the 2% target somewhere around 2025. (Source: Federal Reserve Bank of San Francisco)

The cost of peaking inflation is slower growth. Valetta expects “growth to remain well below trend this year and next year before converging back to trend in 2025.” Conveniently, that return to trend occurs just as inflation returns to the Fed’s target. Most importantly, Valetta points to a mere one percentage point increase in unemployment “through 2024.” This expectation means that the onset of a recession next year will create a mild economic slowdown. Today’s unemployment rate is still near the historic low of 3.5%. Unemployment below 5% is surprisingly low for a recessionary environment. The high job vacancy rate softens the economic blow of slowing growth as there is plenty of room to cool off labor demand without disrupting the labor market.

Valetta acknowledged that the inversion of the yield curve suggests that odds are high for a recession: “such yield curve inversions have proven historically to be reliable predictors of recessions over the subsequent 12 months. After some divergence earlier this year, two leading measures of the yield spread have now both become inverted.” However, Valetta does not want readers to decide that a recession is a foregone conclusion: “their predictions come with substantial statistical uncertainty, however, and are not definitive indications that a recession is looming.”

Inverted yield curves have preceded recessions since the late 1980s.

Inverted yield curves have preceded recessions since the late 1980s. (Source: Federal Reserve Bank of San Francisco)

The Fed’s success in fighting inflation has come from a “proxy funds rate” that is much higher than the effective funds rate. According to the SF Fed, “this measure uses public and private borrowing rates and spreads to infer the broader stance of monetary policy.” The gap between the proxy and effective rate is higher than ever. No wonder Fed Chair Jerome Powell can so comfortably reiterate that the Fed can now slow the pace of rate hikes.

The proxy funds rate is over two percentage points higher than the effective federal funds rates.

With peak inflation finally here, traders and investors should focus on how long the Fed intends to keep a restrictive stance on monetary policy. Given the extended period over which the Fed expects above target inflation, monetary policy should remain restrictive for longer than the market currently expects. In turn, the implication for the stock market of restrictive policy and below trend growth means valuations must come down further and cap upside in market returns for 2023 and perhaps 2024. Time will tell of course.

The S&P 500 (SPY) is out of bear market territory and now trying to fight its way through restrictive monetary policy.

Be careful out there!


Stock Market Loves Powell Moving from “Keep At It” to “Stay the Course” On Fighting Inflation

When Federal Reserve Chair tersely spoke at Jackson Hole on August 26th, he sent a chill through financial markets. Taking on the toughest inflation-fighting tone he could muster, Powell concluded by proclaiming “we will keep at it until we are confident the job is done.” The S&P 500 (SPY) promptly dropped 3.4% on the day. The message was so harsh that it almost took two months for the stock market to bottom out. Fast-forward to Powell’s speech November 30th titled “Inflation and the Labor Market” at the Hutchins Center on Fiscal and Monetary Policy, Brookings Institution in Washington, D.C. Powell concluded by proclaiming “we will stay the course until the job is done.” The S&P 500 promptly rallied 3.1% on the day. The move was bullish enough to close the index above its 200-day moving average (DMA) for the first time in almost 8 months. The S&P 500 also closed above the May, 2021 low. Something about the difference between “keep at it” and “stay the course” significantly mattered to traders!

The S&P 500 (SPY) rallied enough to punch through two important resistance levels. The cumulative losses from Jackson Hole are now almost reversed.

The S&P 500 (SPY) rallied enough to punch through two important resistance levels. The cumulative losses from Jackson Hole are now almost reversed. (Source:

If not for the stock market’s reaction, I would have interpreted Powell’s speech to land somewhere between hawkish as ever and no new information. In fact, there were several key points from the speech which should have told the market the Fed is as serious as ever about sustaining an extended fight against inflation (the following are direct quotes unless otherwise indicated; particularly important quotes in bold):

  • It will take substantially more evidence to give comfort that inflation is actually declining. By any standard, inflation remains much too high.
  • So when will inflation come down? I could answer this question by pointing to the inflation forecasts of private-sector forecasters or of FOMC participant…But forecasts have been predicting just such…a decline for more than a year, while inflation has moved stubbornly sideways.
  • It seems to me likely that the ultimate level of rates will need to be somewhat higher than thought at the time of the September meeting and Summary of Economic Projections. (a reiteration from the November monetary policy meeting)
  • Restoring [supply and demand] balance is likely to require a sustained period of below-trend growth. (another reiteration)
  • Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation. 
  • It is far too early to declare goods inflation vanquished, but if current trends continue, goods prices should begin to exert downward pressure on overall inflation in coming months. (the stock market must have focused on this claim)
  • As long as new lease inflation keeps falling, we would expect housing services inflation to begin falling sometime next year. Indeed, a decline in this inflation underlies most forecasts of declining inflation. (in other words, this claim is old news)
  • We can see that a significant and persistent labor supply shortfall opened up during the pandemic—a shortfall that appears unlikely to fully close anytime soon. (the stock market clearly did not hear this)
  • The labor market, which is especially important for inflation in core services ex housing, shows only tentative signs of rebalancing, and wage growth remains well above levels that would be consistent with 2 percent inflation over time. (in other words the job market is at risk of sustaining high rates of inflation)
  • Despite some promising developments, we have a long way to go in restoring price stability.
  • It makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting. (this is another reiteration, but the stock market seemed to treat this as welcome new news)

If the Fed Fund futures market reversed course and priced in lower peak rates, the stock market’s sudden burst of enthusiasm could have made more sense. However, futures speculators just shifted out the peak 5.00%-5.25% range by one meeting, from March, 2023 to May, 2023. The market did move up the schedule for the first rate cut and ended the year at 25 basis points lower. However, note well that during the Q&A Powell reiterated a warning about the market’s expectations for quick rate cuts: “Cutting rates is not something we want to do soon. That is why we’re slowing down.”

Fed Fund futures market peaked rates at the March, 2023 meeting ahead of Powell’s speech (source: CME FedWatch tool)

Fed Fund futures market peaked rates at the May, 2023 meeting after Powell’s speech and moved the first rate cut up by 5 months (source: CME FedWatch tool)

The day’s rally in the stock market is one of those many times to ignore contrary fundamental assessments and pay attention to what the market thinks. If buyers follow through with the 200DMA breakout on the S&P 500, I will assume seasonal tailwinds are in full flight. Absent any shocks, the market could then rally all the way into the Fed’s December 14th pronouncement on monetary policy. That event will give Powell a fresh chance to redirect financial markets if financial conditions loosen up too much by then. Maybe Powell will have to reiterate how the Fed will “keep at it” instead of “staying the course.”

The Q&A of the Brookings Institution session mainly reiterated points from the speech. There were two points that stirred my interest for future reference.

First of all, Powell actually admitted that the housing market was in a bubble. The conditions he described were easily observable at the time: “coming out of the pandemic, rates were very low, people wanted to buy houses, get out of the cities and move to the suburbs. You had a housing bubble. Had prices going up that were very unsustainable levels, and overheating…” However, of course, the Fed did not dare say the “B” word in the middle of the mania. Powell did not offer any thought on whether the bubble could have been moderated by hiking rates sooner…or at least jawbone about the bubble.

Secondly, Powell mentioned one regret from the 2020 policy framework reset that he mentioned almost as a footnote. Powell indicated that he would not repeat the mistake of relying on a long history of low inflation as a basis for making policy. At the reset, Powell communicated that the Fed would not “lift off” (start hiking rates) until it “saw both maximum employment and price stability.” The stock market soared on this news as it correctly interpreted the change as a Fed more tolerant of a higher range in inflation. Powell admitted that commitment “made us under-estimate tail risk.”

I soundly criticized this pronouncement at 2020’s Jackson Hole. While Powell insisted this mistake has nothing to do with today’s inflation, I continue to insist that this commitment made the Fed slow to respond to rising and then realized inflation risks. Members of the Fed have also dismissed the notion that starting rate hikes a little earlier would have made a material difference in the inflation landscape. We will never know the counterfactual of course. Still, I feel somewhat vindicated that the Fed has taken note of its policy mistake (and prior deflationary bias) and learned some lessons.

Be careful out there!

Appendix: Notes from the Q&A session

Wage increases are going to be a core part of the inflation story going forward.

The labor market has a real supply imbalance

For most workers, wage increases are being eaten up by inflation. Need price stability to get real wage increases.

We assumed that the natural rate of unemployment had gone higher during the pandemic. It’s very hard to pin down where it is when there is a massive disruption.

Used to be able to look through supply shocks. But if we have repeated shocks, it changes things. What are the implications if true? Very hard to know the answers. We tend to think things will return to where they were naturally, but that’s not happening.

Need to be humble and skeptical about inflation forecasts for some time, calls for a risk management framework. If you are waiting for actual evidence for inflation coming down, it is possible to over-tighten. Slowing down is a good way of balancing the risks.

Very few professional forecasters have gotten inflation right.

There isn’t any one summary statistic to determine when policy is sufficiently restrictive. We monitor the tightening of financial conditions (which happens based on expectations). We also look at the effect of these conditions on the economy. Look at the entire rate curve. For significantly positive real rates along the entire curve. Forward inflation expectations reflect confidence in the Fed getting inflation down to 2%. Look at exchange rates, asset prices. Put some weight on these things.

How do you know when you can stop shrinking the balance sheet? This has already been described in a document. We’re in an ample reserves regime. General changes will not impact the funds rate. Will allow reserves to decline until somewhat above where we think is scarcity. Hold the balance sheet constant….. The demand for reserves is not stable. It’s a public benefit to have plenty of liquidity.

Question: August, 2020 announced new flexible inflation targeting framework. Anything in that we should be rethinking. Answer: We will do another review in 2026 or 2026. We implemented through guidance of various kinds. Put in strong guidance because there were a lot doubters that we could ever achieve 2%. Neither did we know. One piece of guidance we wouldn’t do again (it doesn’t have anything to do with the inflation we are currently seeing): we wouldn’t lift off until see saw both maximum employment and price stability. It made us under-estimate tail risk. Remember 25 years of low inflation, inflation just didn’t seem likely.

Cutting rates is not something we want to do soon. That is why we’re slowing down.

It’s not reasonable to expect we get back to the labor force participation in 2020 before the pandemic. But I wouldn’t rule it out. It’s been disappoint and surprising how little we’ve gained back.

We have to assume that for now most of the labor force balancing has to come on the demand side. By slowing job growth, not putting people out of work.

At what point do people ask for more wages because they aren’t keeping up with inflation. Don’t know when that happens, but if it does, you’re in trouble. Labor shortage is not going away anytime soon.

Coming out of the pandemic, rates were very low, people wanted to buy houses, get out of the cities and move to the suburbs, You had a housing bubble. Had prices going up that were very unsustainable levels, and overheating, now the housing market is coming out the other side of that. We have a built-up country, we have zoning, it’s hard to get homes built to meet demand

Full disclosure: long SPY call spread

The Swiss National Bank Knows More About Inflation Than You

Swiss National Bank (SNB) Chairman Thomas Jordan made headlines two days ago in a speech where he insisted that the SNB “will take all measures necessary to bring inflation back into the territory of price stability.” Jordan noted that the current rate, 0.5%, is not restrictive enough to get inflation back into the target range. The Swiss franc surged on a day where the U.S. dollar was already in a deep sell-off after a slightly lower than expected U.S. CPI inflation report. The combined effect completed a reversal for USD/CHF back to the August lows. The below chart from of Invesco CurrencyShares Swiss Franc Trust (FXF) shows a bullish 200-day moving average (DMA) breakout to end the week. FXF gained 2.6% a day after gaining 2.0%.

Jordan set the stage for his market-moving statements in welcoming remarks at the SNB-FRB-BIS High-Level Conference on Global Risk, Uncertainty, and Volatility, November 8-9, 2022 titled “Decision-making under uncertainty: The importance of pragmatism, consistency and determination.” In the speech, Thomas declared “determined action today is consistent with our resolute response to deflationary pressures in the past.” In other words, the SNB is resolute in its inflation-fighting mission and rates will continue higher.

The speech set out a clear blueprint for how the SNB conducts monetary policy in this inflationary environment. The SNB wields an impressive variety of tools that basically says the SNB knows more about inflation than you. Here is a bulleted summary:

  • Disaggregated CPI data
  • A “network of regional representatives who conduct one-on-one discussions about the current economic situation in Switzerland with around 250 company managers throughout the country every quarter.” The SNB collects data on inflation expectations and changes in price-setting behavior.
  • Model simulations and forecasting
  • Risk assessments and cost-benefit analyses
  • Machine-learning models trained on “a large set of economic and alternative indicators” (in an experimentation phase)

This list is a helpful guide for judging counter-observations about inflation from various pundits (including me!).

The SNB’s developing approaches to fighting inflation are not just based on stacks of data and layers of models. The SNB is also grounded by a set of principles. Jordan launched a description of these principals with two rhetorical questions:

“How do policymakers handle this situation of high uncertainty, upside risks to inflation and limited reliability of forecasts? How do they decide when and how strongly to tighten monetary policy?”

The SNB approaches this challenge with a risk management approach. The principles of pragmatism, consistency, and determination orient the SNB’s thinking. Pragmatism requires “policies that exhibit a certain degree of robustness to different circumstances.” Consistency generates monetary policy “…based on a firm commitment to the objective of price stability” that systematically uses all available information. Determination requires “…decisive action…[because] at times, the optimal policy decisions may be those that provide insurance against particularly bad, though very unlikely, events.” Jordan cautioned that “mixed signals on the persistence of inflation might tempt policymakers to postpone further reaction to inflationary pressures until uncertainty about future inflation has receded.” In other words, the damaging risks to inflation are high enough to warrant aggressive action ahead of high degrees of certainty. (The U.S. Federal Reserve deals with this conundrum by relying on the ability to quickly reverse course if monetary policy proves to be too tight).

The SNB’s determination provides the environment or the context for how the SNB decided to finally lift rates out of negative territory. The change started late last year as the SNB “began to tolerate a certain nominal appreciation of the Swiss franc.” The SNB started raising rates in June “to counter the risk of a further build-up of inflationary pressures.” Going forward, the market should expect a combination: higher rates and a stronger Swiss franc.

The Trade

Given these pronouncements, I removed my bias to fade the Swiss franc on rallies. Now, I have a bias to go long. I started with a small short position on EUR/CHF that I plan to grow over time. I will also buy the dips on FXF.

Be careful out there!

Full disclosure: short EUR/CHF

Inflation Expectations and Inflationary Psychology

The Federal Reserve’s aggressive fight against inflation has savaged financial markets. Along the way, I have taken note of bouts of navel-gazing over inflation indicators. Many of us have little operating experience navigating inflation, so perhaps it is natural to get sidetracked staring at an indicator or two that confirms a desire to see an end to inflation or that confirms the persistence of inflation. Since the U.S. last had an inflation problem over 40 years ago, the data samples are quite small for making conclusions for today’s unique mix of ingredients. Yet, since the Fed has expressed fears about entrenched inflationary psychology, consumer expectations for inflation have entered the basket of metrics used for assessing the Fed’s every move.

For example, back in April, 2022, Richard Corbin, a research professor at the University of Michigan who has directed the consumer sentiment surveys since 1976, issued this ominous warning in describing “inflationary psychology”:

“There is a high probability that a self-perpetuating wage-price spiral will develop in the next few years. Households have already become less resistant to paying higher prices and firms have become less resistant to offering higher wages. Prices and wages will continue to spiral upward until the cumulative erosion in inflation-adjusted incomes causes the economy to collapse in recession…

…Although consumers have increasingly expected higher inflation, they have also expected a strong job market and rising wages, especially among consumers under age 45. In the year ahead, wage gains will continue to reduce resistance to rising prices among consumers, and the ability of firms to easily raise their selling prices will continue to reduce their resistance to increasing wages. Thus, the essential ingredients of a self-perpetuating wage-price spiral are now in place: rising inflation accompanied by rising wages.”

Inflationary Psychology Has Set In. Dislodging It Won’t Be Easy” – Richard Corbin

Note well that the University of Michigan’s U.S. consumer sentiment survey showed 1-year inflation expectations last peaked in March at 5.4%. There have been encouraging signs from the subsequent drift downward. However, hopes were dashed that these numbers could convince the Fed to pause after October’s 1-year expectation of 5.1% delivered a significant jump from September’s 4.7%. In other words, at best, expectations may be stabilizing at high levels, especially with core CPI surprising to the upside in September. Note, Corbin warned about over-extrapolating trends from wiggles in inflation numbers:

“Another critical characteristic of the earlier inflation era was frequent temporary reversals in inflation, only to be followed by new peaks. That same pattern should be expected in the months ahead.”

Surveys of Consumers, University of Michigan, University of Michigan: Inflation Expectation© [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis, (Accessed on 10/16/2022, note the data are updated only through August per agreement)

For reference, the 5-year inflation expectations remain just above 2% which indicates consumers are still clinging to confidence that over the “long-term” inflation will return to the “before times”.

Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis, October 16, 2022.

Corbin wrote on the heels of the Fed’s first rate hike which was a mere 25 basis points. Corbin reacted with dismay and presciently argued:

“What was perhaps more surprising was that the quarter-point hike the Fed adopted in March was simply too small to signal an aggressive defense against rising inflation. Instead, it signaled the continuation of a strong labor market along with an inflation rate that would continue to rise.

Much more aggressive policy moves against inflation may arouse some controversy. Nonetheless, they are needed.”

Apparently, the Fed got the message and has been aggressively hiking starting with May’s rate hike!

If inflation expectations remain stubbornly elevated, then the time when the Fed is finally forced to take a pause could present a critical juncture of economic tension. In this scenario, I expect those who applaud the Fed’s pause will dismiss on-going high inflation expectations as transitory or even uninformed. Watch out if those expectations achieve new highs in the wake of a Fed pause.

The current controversy about aggressive policy demonstrates an instructive contrast with the last tightening cycle. What a difference pace can make! The S&P 500 (SPY) (red line with scale on the right) had little problem drifting higher while the Fed tightened with baby steps from 2016 to 2018. A sharp correction in late 2018 helped to convince the Fed to pause and then bring rates down. Market participants are still waiting for the Fed to care about the current market sell-off in the wake of higher rates.

Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; S&P Dow Jones Indices LLC, S&P 500 [SP500], retrieved from FRED, Federal Reserve Bank of St. Louis, October 17, 2022 (data available through September 1, 2022)

Be careful out there!

Full disclosure: short SPY put spread

Why the Fed Won’t Read Cathie Wood’s Open Letter

A Letter or A Plea?

ARK Invest’s Cathie Wood has opposed the Federal Reverse since at least the time the U.S. central bank first hiked rates above zero. Just three weeks after the Fed’s first interest rate hike, with more promised, Wood warned the Fed was making a mistake. On April 2nd, Wood jumped on a market signal from the inversion of the yield curve to underline the point.

The inversion barely lasted 2 days. The yield curve quickly “reverted” for the next 3 months and threw wrenches into the prognostications of a Wall Street looking for a recession to stop the Fed in its tracks. The yield curve inverted again in early July and has yet to look back. Yet, the Fed has become increasingly hawkish even in the face of this traditional signal of a recession. The Fed’s resolution was epitomized by a curt speech at Jackson Hole where Chair Jay Powell stood resolute on the Fed’s inflation fighting mantra.

Source: Board of Governors of the Federal Reserve System (US), Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; October 10, 2022.

So it is no surprise that Wood recently opened a new salvo in her campaign against the Fed’s monetary policy by writing an “open letter to the Fed” to extend her latest criticism in her videocast “In the Know.” In this letter, Wood warns that the Fed is overly focused on lagging indicators from inflation and employment and cannot see the “deflationary bust” that awaits the other side of its aggressive monetary tightening. In many ways, a deflationary bust has already occurred in financial markets. For example, Wood’s flagship fund The ARK Innovation ETF (ARKK) is just a “day’s trade” away from returning to its pandemic lows. Those sudden March, 2020 lows came on the heels of an economic and market crash that was full-force deflation until monetary and fiscal stimulus saved the day.

ARK Innovation ETF (ARKK) long ago lost all its pandemic era gains and how looks set to return to its pandemic crash levels. (Source:

A Deflation Is Already Here

In other words, the deflation that Wood fears has already unfolded in certain financial markets. That pain is felt by anyone invested in the stock market. That pain runs even deeper for those speculating in the companies uncomfortably jostling around in the collection of ARK funds. However, Wood’s letter does not point to prices in her funds. Instead, the letter relies on a series of economic readings showing peak prices and subsequent declines for gold, silver, lumber, iron ore, DRAM, shipping, copper, corn, oil, and container board. The letter points out the ballooning inventories at major U.S. retailers and elements of employment data that show the first signs of a hot labor market finally beginning to cool.

All this complaining across Wall Street and all these data of course beg the question: why is the Fed ignoring it all? However, I think this question is misplaced. For example, Mary Daly, head of the San Francisco Fed, insisted that the Fed is forward looking. She even scolded the market is wrong in expecting rate cuts in 2023. The Fed has hundreds of economists on staff, including the ones who help to curate the charts from the St Louis Fed that I used to show the yield curve inversion. They know everything and more than the economists who get all the attention in the media. So I think it is a stretch to conclude that the Fed has no idea what is going on.

Why the Fed Won’t Read Cathie Wood’s Letter: Speculating on the Fed’s (Unstated) Strategy

Instead, I look to the larger, strategic context. The Fed kept rates too low for too long: the mania in the housing market and stratospheric valuations of profitless companies (again, see the ARK Funds) are sufficient evidence that the Fed should have started the journey toward normalization earlier. Moreover, the Fed has a massive $9 trillion dollar balance sheet that represents a considerable share of the $20 trillion U.S. economy. My guess is the Fed is not hearing the whispers of the famous inflation fighter, former Fed Chair Paul Volcker. Instead, the Fed recognizes the layers of distortions it helped to create in the economy, and it desperately wants to hit the reset button. From the purview of neutral to slightly restrictive policy, it can THEN observe the impact and assess whether the economy can sustain the resulting damage. I also guess that the Fed fully recognizes that the very minute markets sniff a peak in monetary tightening, speculative forces will roar away. Just watch what happens to the ARK Funds in that moment. Indeed, when Wood expected the Fed to cry uncle in July, she anticipated a vindicating resurgence in the ARK Funds.

In this environment where financial markets have become accustomed to easy money and have little experience dealing with inflationary pressures, the Fed is forced to err on the side of being aggressively hawkish as long as it dares possible. The Fed needs to make sure that when the time comes to pause and observe, little to no inflationary embers are left smoldering, ready to reignite with the giddy anticipation of easy money days to come again. As long as employment remains robust and resilient, the Fed can maintain political support for its actions even as support from market participants plummets. The rush to get to neutral or past neutral is likely exactly because the employment window cannot remain open to the Fed for an extended period. The Fed’s actions suggest a strategy for finishing hikes by the time the labor market’s weakness is obvious through an uptrend in the unemployment rate. The Fed has shown itself unmoved by losses in financial markets. So, pundits can throw all the macroeconomic tomatoes they want, the Fed is in over-correction mode for now.

Clinging to the ARK

When the bottom fell out of the ARK Funds, I updated my technical assessment and trading strategy on each of the major funds. I continue to think that the technicals are much more important than the fundamentals here. While the inverse correlation between interest rates and ARK performance is fundamental (surely much to Wood’s chagrin), the technicals of trend-following are sufficient for making trades. At some point, rates WILL peak. I contend the technicals (of trading on extremes) will actually become even MORE important then. Who knows what will be left standing in the ARK funds by that point…

Be careful out there!

Full disclosure: long ARK

Fed’s Daly: The Market Is Wrong About A Hump in 2023 Fed Rates

The Federal Reserve board governors continue to stay on message, reminding the market over and over about its serious intention to fight inflation. San Francisco President Mary Daly has been particularly articulate on the Fed’s plan and what likely lies ahead. In an interview with Bloomberg Finance today, Daly informed financial markets that they are “wrong” to project what the interviewr called a “hump” in rate expectations. This hump is a peak sometime in 2023 with rate cuts to follow soon after. The current view from CME FedWatch has rates peaking from the February through June, 2023 meetings with a rate cut in July.

A peak in the Fed rate from February through June, 2023 and an easing cycle starting with a single rate cut in July.

Daly’s steadfast perspective is important to remember every time the stock market rallies in anticipation of peak inflation and/or a “Fed pivot.” Indeed, Daly warned that the Fed needs to be prepared for inflation to be more persistent than expected. For context, Daly was one who was unwilling to predict peak inflation ahead of what turned out to be the “CPI shocker” that delivered a surprise of higher core inflation. Part of Daly’s persistence comes from what she and the Fed see as inflation’s greater potential for economic harm than the short-term consequences of normalizing monetary policy. Daly noted that over two years real wages have fallen 9%. She even shared an anecdote of a worker who told her about how he “loses” money when he goes to buy something with his earnings (an anecdote that speaks to nominal wages failing to keep up with nominal increases in prices).

Other interesting nuggets from the interview:

  • Rates are probably now around the neutral rate, and the Fed needs to get slightly restrictive.
  • The length of time rates stay neutral (or slightly restrictive) is more important than the specific level.
  • 50% of today’s inflation is driven by demand (thus justifying the Fed’s desire to get slightly above neutral), 50% from supply.
  • Daly refused to take the bait on the question of whether the Fed was purposely trying to induce a recession, trying to force losses on the stock market, or intent on hiking rates until something breaks.
  • Daly insisted the Fed is forward-looking and recognizes lagging indicators of inflation.
  • Daly pushed back on the notion the Fed needs to coordinate with global central banks. She insisted that the Fed must stick to its domestic dual mandate.

While the signs a few months ago were clear from commodity prices that the Fed’s actions were impacting inflation, the recent strength in oil threatens to rekindle inflation fears from the average person. For example, gas prices look like they are already done declining. The United States Gasoline Fund, LP (UGA) broke out today. UGA looks like it double-bottomed in September.

The recent downtrend in United States Gasoline Fund, LP (UGA) came to an end this week with a powerful breakout above 50 and 200DMA resistance.

Similarly, diversified commodities producer BHP Group (BHP) looks like it is holding a bottom in place since late last year.

BHP Group (BHP) has so far held its lows from a year ago. While upside may be limited, BHP also looks like it is done going down for now.

If these bottoms are indicative of what is ahead, then any soft readings in the near-term inflation numbers could be, well, transitory… (tongue-in-cheek intended!)

Be careful out there!

Full disclosure: long BHP

Softening Inflation Expectations Are the Beginning Not the End of the Fed’s Hawkish Posturing

The surprisingly bad CPI report caused shockwaves throughout the stock market. Part of the shock likely occurred thanks to the relatively benign news the day before from the New York Federal Reserve’s August 2022 Survey of Consumer Expectations. Expectations for 1-year-ahead and 3-year-ahead inflation declined significantly in August.

The Fed’s aggressive anti-inflationary posturing is apparently finally having a positive impact on inflation expectations. Source: NY Federal Reserve.

I would caution anyone who wants to declare victory from the return of 3-year-ahead expectations to pre-pandemic levels. Inflation expectations were so well-contained for so many years, it is hard to project the dynamics of going from high to normalized expectations. For example, how long does the Fed need to continue its aggressive posture to maintain this momentum? Moreover, if the 1-year ahead expectation remains predictive, the Fed will have to stay on course tightening policy into 2023 as the Fed Fund Futures currently expect per the CME FedWatch Tool.

The market keeps pushing expectations for peak rates higher and higher in 2023. Suddenly, the market thinks the Fed is on track to reach a 5.0% to 5.25% range but then quickly back down by year-end.

The apparent predictive nature of the 1-year ahead expectation is particularly notable. Both the 1- and 3-year-ahead measures increased steadily a few months into the pandemic. A large gap opened starting in June, 2021 at the same time that the Federal Reserve was convinced that inflation was transitory. The comfortable math of “base effects” allowed the Fed and many others to essentially ignore the soaring inflation expectations. Clearly, the average consumer agreed with me and did not believe the story. Expectations just kept climbing for an entire year. It is only in the last 2 months – in the wake of a Fed that is suddenly consumed with anti-inflation religion – that inflation expectations took a notable downward turn. So while the big drop in August is encouraging, the Fed will likely need to maintain the psychological pressure for some time to keep a lid on expectations.

In turn, this necessary pressure could keep a lid on the stock market for a while. The S&P 500 (SPY) closed the week perfectly testing the line that defines a bear market (a 20% decline from the all-time high). We might have to get accustomed to the index pivoting around or near this important, psychological line.

The press release accompanying the NY Fed’s report included several additional key points indicating the worst of inflationary pressures could be in the rearview mirror if the Fed maintains the pressure.

  • Median five-year-ahead inflation expectations declined to 2.0% from 2.3%.
  • Median home price expectations declined by 1.4 percentage points to 2.1%. This drop represents a dramatic decline from April’s 6.0% and is the lowest reading since July, 2020.

On the other hand, despite inflationary pressures decreasing and respondents reporting declining access to credit, the NY Fed reported “median household spending growth expectations increased by 1.0 percentage point to 7.8%. The increase was driven by those with a high-school degree or less.” At the same time, respondents reported higher odds of missing a minimum debt payment, households felt better about their current and prospective financial condition. Net-net, these numbers tell me that the Fed’s posturing and policy have managed to bring some relief to pricing pressures without crushing economic expectations. These cross-currents will likely resolve in yet unexpected ways.

Be careful out there!

The Reserve Bank of Australia Looks Ahead to Peak Inflation

The peak inflation narrative has become quite popular with those who look for rapid reversions to the mean. Indeed, the Fed may have broken the back of inflation, even as the June CPI (Consumer Price Index) broke the hopes of peak inflation for one more month. Australia is apparently still climbing the hill toward peak inflation. In its latest statement on monetary policy, the Reserve Bank of Australia (RBA) projected peak inflation later this year. Overall, the RBA’s “central forecast is for CPI inflation to be around 7¾ per cent over 2022, a little above 4 per cent over 2023 and around 3 per cent over 2024.”

The Australian economy remains quite strong. The RBA expects growth this year to hit 3.25% and 1.75% in 2023 and 2024. The slowing growth will not cause a significant boost in unemployment which is currently near 50-year lows. This strength gives the RBA room to continue hiking rates as planned. So it is a wonder that the Australian dollar is not faring better against its major rivals in the Japanese yen (AUD/JPY) and the U.S. dollar (AUD/USD). In particular, the Australian dollar looks like it is topping against the Japanese yen with the often dreaded head and shoulders pattern.

The Australian dollar vs the Japanese yen (AUD/JPY) is looking toppy with a broad, 5-month umbrella from the bearish head and shoulder pattern.

AUD/JPY is just one breakdown below the “neckline” away from confirming the topping pattern. (I almost arbitrarily drew the neckline at the point of the last meaningful, tested support level). In the meantime, I am actually betting on a near-term rebound in AUD/JPY before the head and shoulders pattern resolves itself to the downside or upside. The RBA’s monetary policy is racing ahead of the Bank of Japan, so I interpret the yen’s recent general strength as a counter-trend rally or even some kind of short-covering rally. Time should tell soon.

Full disclosure: long AUD/USD, long AUD/JPY

Goldman Sees Entrenched Inflation…Maybe

Entrenched Inflation

There are all sorts of names now for today’s inflation. I still like the concept of “Persistently Elevated, Unactionable Inflation.” In its earnings report this morning, Goldman Sachs (GS) highlighted the prospect for “entrenched inflation.” Again, inflation peaking hardly matters if prices continue to increase at a high rate. In an environment where the Fed is scrambling to normalize monetary policy, entrenched inflation is analogous to unactionable inflation. From Goldman’s Q2 2022 earnings conference call (from the Seeking Alpha transcript):

“We see inflation deeply entrenched in the economy. And what’s unusual about this particular period is that both demand and supply are being affected by exogenous events, namely the pandemic and the war in Ukraine. And my dialogue with CEOs operating big global businesses, they tell me that they continue to see persistent inflation in their supply chains.”


However, in a classic “on the other hand” moment, Goldman also noted that its economist predicts that “….inflation will move lower in the second half of the year.” So which is it? Goldman gave almost no clue from its plans or actions what it really believes about inflation. One potential exception comes from its plan to “reduce certain professional fees going forward.” Goldman referred to this fee cut in the context of improving operating efficiency.

Goldman Definitely Puts Employees On Notice

Operating efficiency is a great euphemism for tightening spending and constraining labor expenses. I took particular note that Goldman may reinstate its annual performance review. The company suspended this review during the pandemic. That gracious move likely took a lot of stress off an already pandemic-stressed workforce. Now, these looming performance reviews will motivate incrementally more productivity and provide a basis for trimming the workforce after year-end in parallel with a slowed “velocity” in hiring.

Conditions Could Improve

Despite an abiding caution, Goldman was quick to point out that conditions could improve.

“We’re being flexible and being prepared to be nimble in case the environment gets worse. By the way, we don’t know that the environment is going to get worse. The environment might get better, too.”

In the context of an inflationary economy, presumably “get better” aligns with the Goldman economist’s prediction of lower inflation pressures in the back half of the year. However, recession/stagflation is a potential side effect of the Fed’s apparent growing success in clamping down on inflation expectations. In other words, to get better, a rebound from recessionary pressures better move VERY fast.

Goldman Sachs Group, Inc (GS) gained 2.5% post-earnings but remains caught in a well-defined downtrend this year. Both the 20-day moving average (DMA) and the 50DMA have guided GS downward.

Goldman Sachs Group, Inc (GS) gained 2.5% post-earnings but remains caught in a well-defined downtrend this year. Both the 20-day moving average (DMA) and the 50DMA have guided GS downward. (Source:

Be careful out there!

Full disclosure: no positions

So Much For Peak Inflation

“How long are we going to keep saying this is the worst of it?”

Carl Quintanilla questioning Brian Deese, National Economic Council Director, about the June inflation numbers – CNBC, July 13, 2022

So much for peak inflation. The Consumer Price Index (CPI) once again came in hotter than “expectations” for both headline and core inflation. The U.S. Bureau of Labor Statistics reported annual June CPI at 9.1%, an increase over May’s 8.6%. Core inflation, excluding food and energy, came in at 5.9%, slightly lower than May’s 6.0%. The monthly increase of 0.7% was slightly higher than the 0.6% of the previous 2 months. The report called the increase in prices “broad based” and “…almost all major component indexes increased over the month.”

Despite being wrong for the last several months, the peak inflation narrative finally has a chance to come through with the next report on inflation. The prices of a large swath of commodities have plunged in recent weeks as it appears the Fed’s aggressive hawkishness is finally breaking the back of inflationary pressures. Financial markets have reflected these declines with large losses for commodity-related stocks. These declines continued today even in the face of the hot inflation print.

However, even if inflation’s momentum abates, prices promise to remain elevated for quite some time. Companies are warning in their earnings reports about this very prospect. For example, PepsiCo, Inc. (PEP) reported yesterday the following observation and expectation on inflation (from the Seeking Alpha transcript of the earnings call):

“Balance of the year inflation is higher than it is for the first half of the year. I think we’ve mentioned in the past, we’re in the teens in terms of commodity inflation. That will continue, but a little bit higher in the back half.”

Company reports are typically more meaningful than the expectations of economists because companies have money on the line and profits at stake.

Ultimately, what matters most is how the Federal Reserve responds to the latest numbers. If the Fed stays the course, inflation’s momentum should take another step down. (Notably, Brian Deese acknowledged on CNBC that core inflation remains too high and outlined the myriad of inflation-fighting initiatives underway by the administration). If the Fed gives in to pressures to slow down and also communicates its belief that its job is near an end, I fully expect a massive rally in financial markets and asset prices…at least in the short-term. If the Bank of Canada’s large (and surprise) 1 percentage point increase in its interest rate is any indication today, the Fed will stay on message.

Be careful out there!

The Fed’s Hawkish Pressure Is Working Against Inflation

The Federal Reserve has stuck by its aggressively hawkish stance despite massive pains suffered in financial markets and growing risks of a recession. Markets are so convinced by and so scared of the Fed that they have raced far ahead of current policy to anticipate a lot of price hikes ahead. Soaring mortgage rates are one example of the Fed’s sharp impact. The 30-year fixed rate mortgage was last this high during the recession of the Great Financial Crisis (GFC).

Source: Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; June 28, 2022.
Source: Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; June 28, 2022.

These suffocating mortgage rates are an important sign of victory for a Fed whose primary inflation concerns come from housing.

An even clearer sign of victory comes from the bond market, specifically the breakeven rates on five- and 10-year Treasury Inflation-Protected Securities (TIPS). Reuters reported that these TIPS “slid to 2.636% and 2.362%, respectively, a level last seen in September 2021.” Nancy Davis, managing partner and chief investment officer at Quadratic Capital Management LLC, accordingly observed that “the breakeven market, the difference between TIPS versus regular Treasuries, is dramatically downward sloping. It’s barely above the Fed’s long-term average (inflation) target of 2%.” In other words, the bond market is already anticipating that the Fed’s aggressive push to normalize monetary policy and fight inflation will work.

A broad swath of commodities and commodity-related stocks are suffering under the weight of the Fed’s success. The charts below are just a sample: diversified commodities producer BHP Group Limited (BHP), iron ore producer Rio Tinto (RIO), copper producer Freeport McMoRan (FCX), and the metals and mining ETF (XME) (charts from Even agricultural commodities like corn and lumber look like they have topped. Perhaps these declines represent the early signals of a recession. If so, those concerns may wait for a post-inflationary day.

BHP printed a double-top in 2022 BELOW the 2021 highs.

BHP printed a double-top in 2022 BELOW the 2021 highs.

RIO topped out in 2022 well below 2021's highs. It now trades at the November, 2021 low and is at risk of challenging the November, 2020 low.

RIO topped out in 2022 well below 2021’s highs. It now trades at the November, 2021 low and is at risk of challenging the November, 2020 low.

FCX is close to erasing ALL its 2021 gains.

FCX is close to erasing ALL its 2021 gains.

The SPDR S&P Metals & Mining ETF (XME) quickly reversed its entire 2022 breakout.

Spot corn prices closed below the uptrending 200-day moving average for the first time since January. The topping formation for 2022 looks like the dreaded head and shoulders top (shoulders in March and June, the head in April).

Spot corn prices closed below the uptrending 200-day moving average for the first time since January. The topping formation for 2022 looks like the dreaded head and shoulders top (shoulders in March and June, the head in April).

Lumber prices topped out in 2022 well below the 2021 highs.

Lumber prices topped out in 2022 well below the 2021 highs.

Be careful out there!

Full disclosure: no positions

Growing Inflationary Pressures Force Even the Swiss National Bank to Hike Rates

The financial world last saw the Swiss National Bank (SNB) hike its interest rate back in 2007. It took “signs of inflation also spreading to goods and services that are not directly affected by the war in Ukraine and the consequences of the pandemic” to force the SNB’s hand (from the Introductory remarks by Thomas Jordan, head of the SNB). The rate move from -0.25% to -0.75% took financial markets by surprise and sent the Swiss franc soaring. USD/CHF declined 2.8% on the day in a move that may have created a double top.

The SNB insisted that “the tighter monetary policy is aimed at preventing inflation from
spreading more broadly to goods and services in Switzerland.” While the SNB also warned that these inflationary pressures may force the SNB to increase rates further, its current forecast for inflation at the -0.25% rate is for inflation to return to the 2% target starting next year. Note the significant increase in the inflation forecast since March (the red line over the yellow line).

The fast transmission of price increases also caught the SNB’s concern: “…price
increases are being passed on more quickly – and are also being more readily accepted – than
was the case until recently.” This acceptance is one of the drivers of higher inflation expectations that can lead to stubbornly high inflation. Moreover, second order inflation effects are threatening the inflation outlook. Interestingly, weakness in the Swiss franc is suddenly working against the SNB’s attempts to avoid deflation: “the Swiss franc has depreciated in trade-weighted terms, despite the higher inflation abroad. Thus the inflation imported from abroad into Switzerland has increased.” This comment makes me much less inclined to short the Swiss franc going forward.

In other words, the Swiss economy has been hit from all angles with price-related shocks. Content to keep rates at -0.25% for so many years, the SNB had to respond with a rate hike. With another 50 basis point hike on the table, the SNB has joined a growing chorus of central banks scrambling to normalize monetary policy. The race to the bottom of devaluation suddenly reversed this year.

Be careful out there!

Persistently Elevated, Unactionable Inflation

Bonawyn Eison, CNBC Fast Money commentator, used the phrase “persistently elevated, unactionable inflation” to describe the current inflationary cycle. Ahead of the disappointing report on May inflation, Eison pushed back on the “peak inflation” narrative as part of an attempt to “reverse engineer” a reason to buy the stock market. While he framed the desperate gaze over the inflation horizon in stock market terms, his characterization is quite appropriate for today’s overall inflation problem. Inflation has been persistent thanks to a powerful convergence of massive monetary stimulus, equally potent fiscal stimulus, and a host of economic disruptions. In turn, inflation promises to remain elevated for quite some time. Perhaps most importantly, the tools for fighting inflation are small compared to the size and the near intractability of the problem. For the Federal Reserve in particular the path to fighting inflation is fraught with the economic perils of stagflation.

The lure of the “peak inflation” narrative has been strong since the report on March inflation. The appeal is natural because of the sense that over time all economic conditions revert to the mean (or the average). However, the rush to declare the end of today’s problem with inflation has been particularly meaningful because it occurs in the middle of a desperate, global desire to return to some form of the “normalcy” we (think) we enjoyed before the pandemic. To their credit, various Federal Reserve members tried to soft pedal the idea of peak inflation, including the San Francisco President back in late April. They have remained nearly uniform in their stated resolve to focus on fighting inflation. The path from 8.6% to anything close to the Fed’s comfort zone does not start with hoping for a peak in inflation.

That 8.6% is where the headline Consumer Price Index (CPI) hit in May. Inflation hurtled March’s 8.5% for a new high for this inflationary cycle. The “peak inflation” crowd might now think surely inflation cannot go any higher from here. Perhaps this hope works out this time, but it matters little in the face of persistent and elevated inflation. Moreover, on the same Fast Money episode featuring Eison’s commentary, Lindsey Piegza, chief economist at Stifel, made an excellent point about the lagging nature of the CPI. Piegza pointed out that the worst impacts of the Russian invasion of Ukraine and the COVID lockdowns in China have yet to hit the CPI. If so, CPI may not continue to increase, but inflation will remain high for quite some time.

The broad-based nature of the May CPI increases suggests that inflation will indeed remain far above the Fed’s comfort zone for quite some time. Both the month-over-month and, of course, year-over-year inflation numbers were elevated across major categories (numbers are monthly and then year-over-year):

  • Food: 1.0% and 8.6%
  • Energy: 3.9% and 34.6%
  • All items less food and energy: 0.6% and 6.0%
  • New vehicles: 1.0% and 12.6%
  • Used cars: 1.8% and 16.0%
  • Shelter: 0.6% and 5.5%

The persistent rise in shelter costs is particularly notable given the Fed’s sudden sense of urgency on normalizing monetary policy implicitly came from housing costs.

I see at least one lesson from these numbers: inflation will not peak until it peaks. In other words, there is little point in straining the eyes over the horizon seeking the end of this inflationary cycle. Whatever the specific numbers, inflation here in the U.S. and across many nations promises to be persistent and elevated and will frustrate the economic agent who try to act against it without causing other economic fallout.

Be careful out there!

SF Fed President Maps the Path Toward Neutral Policy, Not Banking On “Peak Inflation”

More hawkish, anti-inflation commentary from Fed Chair Jerome Powell got top billing today in financial markets. While Powell said nothing new or surprising, he got the blame for a downdraft in stock markets. However, the head of the San Francisco Federal Reserve caught more attention for Inflation Watch. In a great scoop for Yahoo Finance, San Francisco Fed President Mary Daly gave a 15-minute interview discussing her stance on monetary policy. Daly crisply aligned with the new hawkish mood on the Fed. At the same time, she provided clear guidance on the Fed’s objectives and assessments of the current inflationary economy. I recommend watching the video embedded in the article. Otherwise, here are the key highlights and take-aways as you get ready for the May Fed meeting.

  • “The Fed is expeditiously marching towards neutral. It is clear the economy doesn’t need the accommodation that we’re providing” – notice the recognition that current policy is over-stimulative. Maintaining an easy money policy while the economy is strong is not only bad policy, but also doing so increases inflation risks.
  • “The neutral rate is about 2.5% by the end of the year” – this statement sets the stage for several 50 basis point rate hikes this year given rates are still at a paltry 0.25%-0.50%.
  • “We don’t want to go so quickly or so abruptly that we surprise Americans and make them have to adjust quickly…” – the Fed never likes to create downside surprises, only upside ones. Indeed, Daly observed that tightening financial conditions are already tapping on the economy’s brakes. She pointed to mortgage rates as a prime example; a notable reference given a hot housing market is at the center of the Fed’s concerns.
  • Daly insisted that the Fed can pull off a soft-landing.
  • Daly cautioned that predicting “peak inflation” is “fraught with peril” given on-going COVID shutdowns in China and Russia’s invasion of Ukraine.
  • “High inflation is as bad for workers as not having a job” – in other words, the Fed cannot afford to allow inflation to erode spending power on a sustained basis.
  • The Fed funds rate is more precise than and better known for moving monetary policy.

Compare Daly’s comments to this key quote from Powell today:

“It may be that the actual [inflation] peak was in March, but we don’t know that, so we’re not going to count on it…We’re really going to be raising rates and getting expeditiously to levels that are more neutral and then that are actually tight … if that turns out to be appropriate once we get there.”

The Fed is all-aboard the anti-inflation locomotive!

Jim Bianco: “Arguably One of the Worst Forecasts In Fed History”

I thought *I* was critical of the Fed waiting so long to start normalizing monetary policy! Jim Bianco, President of Bianco Research, LLC, took criticism of the now moribund “transitory inflation” narrative to a new extreme. In an interview with CNBC’s Fast Money, Bianco took the Fed to task for what he called “arguably one of the worst forecasts in Federal Reserve history.” As a result, the Fed finds itself stuck with an inappropriately loose monetary in the middle of a high price, supply-constrained economy. The Fed intends to dampen demand through higher borrowing costs and lower stock prices (the wealth effect). The historic gap between job openings and the number of unemployed gives the Fed plenty of room to hike rates (until something breaks).

Fast Money invited Bianco after noticing an extended twitter thread that also took the stock market to task for ignoring rate hike risks. Bianco noted the dichotomy between a bond market that understands the Fed is more focused on controlling prices than growth, and a stock market that keeps doing its best to ignore the prospects. Bianco’s charts show that “the carnage is epic” in the bond market: “This is not only the worst bond market in our career (total return) but might be the worst of our lifetime.” Meanwhile, Bianco insists that what is ahead will hurt all financial assets.

The Trade

In “The Market Breadth“, I specialize in market opportunities at the extremes of behavior. So hearing that the bond market is suffering historic losses actually intrigues me. I suspect that sometime in the middle of an aggressive tightening cycle, bonds will present a generational buying opportunity. I am not a student of bond markets, so I will have to rely on the technical signals from a proxy bond instrument like the iShares 20+ Year Treasury Bond ETF (TLT). The weekly chart below suggests that the opportunity zone on TLT sits somewhere between the 2013 lows (government shutdown drama) and the lows of the financial crisis. I assume the lows of 2018 will be an insufficient stopping point, but I will watch closely for a bounce at that level. On the way down, I have been fading TLT rallies with put options.

The iShares 20+ Year Treasury Bond ETF (TLT) is in a bear market with a 26% drawdown from its all-time high during the stock market crash of March, 2020.

Be careful out there!

Full disclosure: no positions

Low Wage Pressures Suppressing Inflation In Australia

Earlier this week the Reserve Bank of Australia (RBA) released its latest decision on monetary policy. I was surprised to read that inflation remains relatively low in Australia compared to other industrialized countries. From the RBA:

“Inflation has increased in Australia, but it remains lower than in many other countries; in underlying terms, inflation is 2.6 per cent and in headline terms it is 3.5 per cent.”

Seeing that data, I wondered whether the soaring prices of commodity exports and the resulting stronger Australian dollar are helping tamp down inflation. The RBA mentioned neither of these potential drivers. Instead, the central bank fingered low wage pressures:

“Wages growth has picked up, but, at the aggregate level, is only around the relatively low rates prevailing before the pandemic…Inflation has picked up and a further increase is expected, but growth in labour costs has been below rates that are likely to be consistent with inflation being sustainably at target. “

This sluggish wage growth is giving the RBA the luxury of standing still on monetary policy. The statement gave no hint of a specific time horizon for tightening rates. The RBA is waiting for “…evidence that inflation is sustainably within the 2 to 3 per cent target range before it increases interest rates.” In other words, wage growth is so slow that there are risks to the downside for inflation.

The Australian dollar reacted well in advance of and following the statement. A larger sell-off in financial markets the next two days reversed all the gains for AUD/USD.

The Australian dollar vs the U.S. dollar (AUD/USD) is pulling back in the face of hawkish minutes from the U.S. Federal Reserve.
The Australian dollar vs the U.S. dollar (AUD/USD) is pulling back in the face of hawkish minutes from the U.S. Federal Reserve.

Be careful out there!
Full disclosure: short AUD/USD

The Federal Reserve Fears On-Going Inflationary Pressures from Rents

I recently complained about the Fed’s belated sense of urgency in trying to get inflation under control. The Federal Reserve Bank of St. Louis shed some light on the specific points of concern for the Federal Reserve. In an economic article titled “Breaking Down the Contributors to High Inflation“, the St. Louis Fed described a 12-month lag for housing price dynamics to feed into rents. Given the soaring prices of housing for over a year, rents are due to soar from already high levels for at least the next year or so. Here is the instructive chart:

The Fed’s core concern comes from the out-sized influence of housing services on the PCE (Personal Consumption Expenditures): “Given that housing services constitutes the largest subcomponent of PCE, accounting for roughly 18% of total consumption expenditures, the impact of housing services inflation on overall PCE inflation is always significant.” In other words, I interpret the Fed’s recent religion on normalizing interest policy as a belated attempt to cool down price appreciation in the housing market.

The St. Louis Fed also put this concern in context by comparing today’s inflation with the inflation from the last economic expansion from July 2010 to January 2020. Interestingly each of the three components of the PCE – durable goods, non-durable goods, and services – have contributed around the same amount of extra inflationary pressure in absolute terms, ranging from 1.46 to 1.71 percentage points. However, with a 65% of total consumption expenditures, the promise of on-going upward pressure on services inflation promises to drive the overall PCE ever higher. The Fed finally could no longer sit still on rates.

(For a good read on belated inflation concerns, review Jason Furman’s critique of the economics profession: “Why Did Almost Nobody See Inflation Coming?“)

Be careful out there!

Full disclosure: no positions

An Attempt to Explain Today’s Lower Inflationary Pressures In Japan

In a world of soaring commodity prices, major commodity importers should worry about increasing inflation risks. Japan is the world’s fifth largest importer with at least its top 5 imports consisting of commodities: crude oil, coal briquettes, petroleum gas, refined petroleum, and iron ore. Yet, the Bank of Japan is not much worried about inflation risks. In an important speech on March 29, 2022 AMAMIYA Masayoshi, the Deputy Governor of the Bank of Japan, described inflation as a problem for the U.S. and Europe but not for Japan. In “The COVID-19 Crisis and Inflation Dynamics: Opening Remarks at the Workshop on ‘Issues Surrounding Price Developments during the COVID-19 Pandemic‘, Masayoshi offered several explanations for Japan’s lower modest 2% increase for its consumer price index (CPI):

  • Japan experienced a limited shift in demand. In the U.S. in particular, a sharp shift from services to goods consumption created severe supply shortages which in turn helped drive up prices.
  • A strong risk aversion in Japan limited pent-up demand for private consumption. As a result, Japan did not experience disruptive shifts in demand. Japanese conservatism has also anchored labor mobility, a key ingredient for the kind of wage pressures that can contribute to inflation.
  • The waning of the pandemic has revived the Japanese corporate “norm” of deflationary thinking – the “assumption that prices will not increase easily.” Accordingly, unlike U.S. firms, Japanese firms prefer to focus on long-term business relationships and are reluctant to increase prices. According to Masayoshi, “When there are supply-side constraints for certain goods, U.S. firms tend to raise prices relatively quickly and allocate goods by giving preference to customers who are willing to pay higher prices. In contrast, Japanese firms seem to place more emphasis on long-term business relationships with customers and respond to their demand as much as possible while keeping selling prices unchanged.”
  • Service prices remain relatively weaker in Japan (although Masayoshi called on a review of statistical practices).

Masayoshi concluded with the claim that “our understanding of inflation remains limited.” Despite this purported limited understanding, the Bank of Japan is quite confident enough to buy an unlimited amount of bonds to defend its ultra-low interest rates. Last week the BoJ surprised financial markets with this vigorous defense of its zero interest rate policy (ZIRP). The immediate reaction in the currency market sent an already rapidly weakening yen even lower. The rush to sell more yen created a (likely temporary) exhaustion of sellers. The yen rebounded for three days before selling resumed on Friday.

A divergence in monetary policy is helping to grease the skids for the yen. Last week, the Invesco CurrencyShares Japanese Yen Trust (FXY) plunged to an all-time low (since 2007).

As long as a differential in inflationary expectations exists between Japan and the U.S., the downward pressure on the yen should also persist.

Be careful out there!

Full disclosure: long FXY put options

Transitory Complete: Fed Chair Jay Powell Gets Comfortable With the Inflation Hawks

Transitory Complete

Pandemic-era inflation pressures were not transitory after all. The inflation watchers I follow never believed the narrative given the Fed’s insistence on maintaining historically accommodative policy well past its expiration date. Indeed, the transitory in the economy turned out to be the deflationary psychology of Federal Reserve Chair Jerome Powell.

The journey has been quite a ride for Fed-speak. In July 2020, Powell reassured an economy in lockdown shock that the Fed is “not thinking about thinking about raising rates.” When murmurs and then gripes about creeping inflation emerged in early 2021, Powell insisted inflation pressures would be transitory. In late April of that year, Powell explained the theory at that time behind transitory inflation. Transitory stretched out longer and longer and longer, until finally in December, 2021 testimony Powell essentially asked everyone to leave him alone about the unfortunate and untimely phrase. Now, with inflationary pressures worsening, Powell has found inflationista fervor. Powell even declared that the Fed is ready to take rates higher than the neutral rate. The mad scramble has begun; the Fed wants to get a raging fire under control.

A Pivotal Speech

Today, March 21, 2022, Powell gave what I think is the pivotal speech of his career as Fed chair. With the appropriately ominous title “Restoring Price Stability“, Powell started with this proclamation to the 38th Annual Economic Policy Conference National Association for Business Economics assembled in Washington, D.C. (emphasis mine):

“…the current picture is plain to see: The labor market is very strong, and inflation is much too high. My colleagues and I are acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation. There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability. We are committed to restoring price stability while preserving a strong labor market.”

For the folks who might still be in transitory thinking, Powell went on to clarify “…the inflation outlook had deteriorated significantly this year even before Russia’s invasion of Ukraine.”

In racing against the wildfire, Powell and the Fed have an ambitious goal. They want to avoid a recession by tapping the brakes on excessive demand in the economy just enough to gently match limited supply. The strong labor market is both a blessing and a curse in this effort. Powell did not use the term “wage-price spiral” inflation spiral”, but he essentially described such a potential dynamic for today’s economy. Companies are struggling to hire. Employees are shifting into new jobs to gain higher wages.

“There are far more job openings going unfilled today than before the pandemic, despite today’s unemployment rate being higher. Indeed, there are a record 1.7 posted job openings for each person who is looking for work. Record numbers of people are quitting jobs each month, typically to take another job with higher pay. And nominal wages are rising at the fastest pace in decades, with the gains strongest for those at the lower end of the wage distribution and among production and nonsupervisory workers”

Powell summarized: “Overall, the labor market is strong but showing a clear imbalance of supply and demand.” Thus, the Fed feels compelled to “moderate demand growth.” In the process the Fed hopes that the labor market’s very strength will withstand a period of aggressive monetary tightening.

Powell explained that the big surprise came from the stubborn persistence of “supply-side frictions.” The economy cannot handle the rapacious demand in today’s economy without sending prices ever higher. In turn, spiraling inflation threatens to erode wage gains especially for lower-income workers.

No Time to Wait Anymore

Interestingly, Powell provided automobile prices as a good example of the inflation problem. There was a time when commentators insisted soaring car prices would be transitory. Auto prices are now transitory complete. Powell lamented “production remains below pre-pandemic levels, and an expected sharp decline in prices has been repeatedly postponed.” Prices for new cars soared almost all of last year and suddenly look ready to take off again. Used car prices soared even more and could lift again if new car prices rev up again. Regardless, no “base effects” here as worker’s wage gains look sure to come under more pressure.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: New Vehicles in U.S. City Average [CUSR0000SETA01], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: New Vehicles in U.S. City Average [CUSR0000SETA01], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Used Cars and Trucks in U.S. City Average [CUSR0000SETA02], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

These mounting pressures have forced the Fed’s hand. The Fed senses it has no time to wait anymore. The Fed is no longer content to wait for the conventional expectations of normalization to bear fruit. In an inflation emergency the Fed needs to act now… (emphasis mine).

“It continues to seem likely that hoped-for supply-side healing will come over time as the world ultimately settles into some new normal, but the timing and scope of that relief are highly uncertain. In the meantime, as we set policy, we will be looking to actual progress on these issues and not assuming significant near-term supply-side relief.”

Inflation is so strong now that Powell has to look out 3 years to envision inflation returning to the Fed’s target of 2%: “I believe that these policy actions and those to come will help bring inflation down near 2 percent over the next 3 years.”

Recession? What Recession?

No Federal Reserve has ever predicted a recession. The central agent trying to command the economy has a vested interest in projecting utmost confidence in its navigation abilities. Accordingly, Powell looked to history as proof that the Fed can pull off the spectacle of the soft landing for the economy:

“I believe that the historical record provides some grounds for optimism: Soft, or at least soft-ish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession…In other cases, recessions chronologically followed the conclusion of a tightening cycle, but the recessions were not apparently due to excessive tightening of monetary policy. For example, the tightening from 2015 to 2019 was followed by the pandemic-induced recession.”

The Fed is also encouraged by an economy “well positioned to handle tighter monetary policy.”

Powell formerly insisted the Fed would hold rates lower for longer in order to achieve an exceptionally low unemployment rate. The current path flips to the opposite direction. The Fed is willing to go right past the point of neutral rates to get the fire under control: “if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.”

Transitory complete. Bring on the inflation hawks.

Be careful out there!

PPG Industries Warns of Intensifying Inflation Pressures and Weakening Demand

{Originally published on One-Twenty Two by Dr. Duru}

““As we look ahead, we currently do not anticipate any relief from inflationary cost pressures in the third quarter. We expect aggregate global economic growth to remain positive with end-use market activity comparable to the second quarter, adjusted for traditionally lower seasonal demand. However, uncertainties exist regarding global trade policies, which may create uneven demand by region and in certain industries. Specific to PPG, we expect that the previously announced architectural customer assortment change will lower our third quarter year-over-year sales volume growth rate by between 120 and 150 basis points. We remain confident that our leading-edge technologies and products, which are bringing value to our customers, will facilitate our growth going forward….

Currently the new tariffs are starting to add some modest cost to our raw materials. Based on the strength in the US dollar in the second quarter, we expect foreign currency exchange rates to have an unfavorable impact to our sales in the third quarter”

This was the essence of the guidance industrial paint company PPG Industries (PPG) provided in its 2nd quarter earnings report. I added the emphases because the warnings on inflation and international demand were clear precursors to the company’s pre-earnings warning tonight. The stock traded down about 10% in after market trading in response to significant cuts in revenue and earnings guidance. I was most interested in the explanation which made the second quarter’s caution come to life (emphases mine)…

““In the third quarter, we continued to experience significant raw material and elevating logistics cost inflation, including the effects from higher epoxy resin and increasing oil prices…These inflationary impacts increased during the quarter and, as a result, we experienced the highest level of cost inflation since the cycle began two years ago.

“Also, during the quarter, we saw overall demand in China soften, and we experienced weaker automotive refinish sales as several of our U.S. and European customers are carrying high inventory levels due to lower end-use market demand…Finally, the impact from weakening foreign currencies, primarily in emerging regions, has resulted in a year-over-year decrease in income of about $15 million. This lower demand, coupled with the currency effects, was impactful to our year-over-year earnings and is expected to continue for the balance of the year.”

Instead of moderating, inflationary pressures are mounting on PPG. The weakness in China is telling in the context of the trade war with the U.S. The lower “end-use market demand” points to the trickle-down impact of “peak auto.” These warnings are each important given PPG has a market cap of $26.5B and trailing 12-month revenue of $15.4B. I fully expect other industrial companies to deliver similar news this earnings season.

Interestingly, Credit Suisse downgraded the stock in late September and the market responded by taking PPG down 2.8% on relatively high trading volume. The gap down confirmed the end of PPG’s post-earnings run and breakout above 200-day moving average (DMA) resistance. Until the downgrade the stock finally looked ready to challenge its 2018 high.

PPG Industries (PPG) never quite recovered from the February swoon. The recent breakdowns below 50 and 200DMA supports now look like fresh warnings.
PPG Industries (PPG) never quite recovered from the February swoon. The recent breakdowns below 50 and 200DMA supports now look like fresh warnings.

Source: FreeStockCharts.comThe market is supposed to be a forward-looking mechanism, so it is natural to wonder why PPG was rallying so well in the first place. I do not put all the blame on investors. I assume the company itself was partially responsible through its sizable share repurchase program. For the first half of 2018, PPG spent $1.1B on its own shares: 4.1% of the company’s current market capitalization. With this kind of aggressiveness, PPG should quickly move in on the new 52-week low to add to take out even more shares.

As earnings season unfolds, I will be paying close attention to company commentary on trade woes and inflation. The stock market has spent most of the past several months ignoring risks, so there are a good group of over-priced stocks out there waiting their turn for a douse of realty. Collectively, these warnings could be the catalyst that delivers the oversold market conditions I am anticipating.

Full disclosure: no positions