Don’t Blame the Fed: The Fed Gives Us What We WantPosted: March 21, 2023 Filed under: commodities, Economy, gold | Tags: CME FedWatch Tool, Fed balance sheet, Fed Fund Futures, Federal Reserve, gold, Jim Chanos, Monetary Policy, National Financial Conditions Index, NFCI, Panic of 2023, PHYS, SBNY, Signature Bank, Silicon Valley Bank, Sprott Physical Gold Trust ETV, SVB, SVB Financial Group 2 Comments
The Fed’s risk management strategy was ostensibly designed to keep pushing rates higher until the Fed slayed the inflation dragon or something in the economy forced it to stand down, whichever came first. Unfortunately for the Fed, the dice rolled in favor of the latter. Instead of a soft landing or even a mild recession, bank failures landed on the Fed’s collective lap in the form of SVB Financial Group (SVB), the parent company of Silicon Valley Bank, and Signature Bank (SBNY). It is very easy to blame the Fed for this mess (today’s chorus is pretty emphatic on this point). However, the problems in Silicon Valley Bank (SVB), which was the strongest catalyst for the Panic of 2023, started well before the Fed belatedly decided to start tightening monetary policy. ABC News confirmed reports from the New York Times and the Wall Street Journal on the following timeline:
- Starting in 2019: The Federal Reserve warned Silicon Valley Bank about risks in the bank.
- 2021: “The Fed identified significant vulnerabilities in the bank’s containment of risk, but the bank did not rectify the weaknesses.” Ironically enough, one of the six fines issued to SVB included “a note on the bank’s failure to retain enough accessible cash for a potential downturn.”
- July, 2022: a full supervisory review revealed the bank as “deficient for governance and controls.”
- Fall 2022: the Federal Reserve of San Francisco met with “top officials at the bank to address the lack of accessible cash and the potential risks posed by rising interest rates.”
In other words, tight monetary policy was not the root problem of the bank’s problems. Tighter monetary conditions finally forced the issue of disciplining the bank. Tighter monetary policy is supposed to mop up excesses in the economy, and Silicon Valley Bank is starting to look like yet one more egregious example of the excess enabled by the prior era of easy money. It will be interesting to see whether the Fed’s review of its regulatory supervision includes claims that it lacked the authority to force SVB to change its ways.
The Fed Gives Us What We Want
Regardless, as I continue to see blame heaped on the Fed for this latest episode of financial instability, I have surprisingly adopted a more sympathetic view of the Fed’s work. The Federal Reserve has a near impossible job. It seems every major change in monetary policy sets the seeds for the next financial drama. Every financial drama raises the Fed’s prominence yet higher as a centralized economic planner, never able to return to the background of a free market. The Fed now must constantly tinker with interest rates with no clear terminal point. In particular, the economy has set up the Fed to bias towards keeping monetary policy as accommodative as possible for as long as possible. The Fed gives us what we want: policy that supports higher asset prices from stocks to real estate.
The index of financial conditions, as measured by the National Financial Conditions Index (NFCI), since the Great Financial Crisis (GFC) shows extended periods of very easy financial conditions. It is remarkable how little time the economy has been stuck with a positive index, or even a component on the positive side of danger…even in the aftermath of the economic shutdowns from the pandemic.
The Fed’s balance sheet is an even better example of how the Fed gives us what we want in the form of accommodative monetary policy. The Fed was never able to reduce its balance sheet after the GFC. The current tightening cycle barely put a dent in the Fed’s balance sheet. I have a sneaking suspicion that the Fed will never get its balance sheet back to pre-pandemic levels either. Note how the balance sheet ticked up as of last Wednesday in the wake of the rescue programs rolled out to backstop failing banks.
Board of Governors of the Federal Reserve System (US), Assets: Total Assets: Total Assets: Wednesday Level [RESPPANWW], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2023.
Before the GFC, this kind of balance sheet expansion was considered unthinkable. Surely, such a growth in the balance sheet would cause dangerous inflation levels. Given the on-going duration and size of this expansion, I am guessing economic theories will slowly but surely normalize the existence of this balance sheet. Yet, the longer this largesse continues, the more the economy will depend on sustaining these high levels. Thus, the economy will remain vulnerable to instability whenever economic conditions force the Fed into tightening policy. (Recall how the previous tightening cycle moved at a snail’s pace but still eventually forced the entry of a “Plunge Protection Team” to put a floor under the stock market).
What We Want Is Not Free
In a July, 2022 interview on Bloomberg’s Odd Lots (starting at the 14:35 point), famous short-seller Jim Chanos presciently claimed (emphasis mine):
“The one thing people are not prepared for is interest rates resetting meaningfully higher…It just hasn’t happened in most investors’ lifetimes…the idea that actually interest rates are not going to be 2 or 3% for the foreseeable future is going to be hard for a lot of investors to deal with. If we go back to what I would think are more reasonable rates based on what we’re seeing in the economy…this market will not be able to handle 5 or 6% 10-year. It just won’t. So many business models that we look at are extremely low return on invested capital because capital has been so plentiful for the past 12 years.”
The subtext here is that the Fed’s bias has been to leave monetary policy as accommodative as possible for as long as possible. Deflation was the great imperative chasing the Fed into monetary corners. The response to the pandemic was the logical conclusion of this policy as the Fed decided it had the luxury to keep driving unemployment ever lower by holding rates lower for longer. The economy appeared to be in another era where liquidity and massive stimulus could be conjured up for free. The pandemic’s inflationary pulse eventually turned the tables. What we want can actually be quite costly.
Thus, the Fed finds itself in a new trap. I feel for the Fed, but I don’t blame them…we prefer easy money…and many eagerly await the Fed getting disciplined back into cooperation by the Panic of 2023. The Fed Fund futures suddenly expect a long string of rate cuts to follow peak rates in May. I sure hope inflation cooperates as well!
Source: CME FedWatch Tool as of March 21, 2023
A Golden Epilogue
Gold received a new burst of life thanks to the Panic of 2023. As soon as the Fed blinks, I expect gold to rally further. I am keeping the buy button close as we go into the next several decisions on monetary policy starting with March’s. The Sprott Physical Gold Trust ETV (PHYS) broke out to an 11-month high. Today’s 2.0% pullback from over-extended price action looks like it is setting up the next buying opportunity.
Be careful out there!
Full disclosure: long GLD
An Inflation Downtrend Quickly EvaporatesPosted: February 24, 2023 Filed under: Bond market, Economy | Tags: Federal Reserve, iShares 20+ Year Treasury Bond ETF, PCE, Personal Consumption Expenditures, S&P 500, SPY, technical analysis, TLT Leave a comment
Some inflation analysts have enthusiastically contorted the inflation data to dismiss today’s inflation problem and/or conclude that inflation’s run came to an end months ago (since last year’s peak). One method of dismissal came in the form of a downtrend in the monthly change in the core Personal Consumption Expenditures (PCE) starting conveniently at the peak as far down as November’s relatively benign reading. (Alan Binder used a related method dividing inflation into different time periods). Suddenly, with two consecutive up months that inflation downtrend has evaporated. The mist leaves behind what essentially looks like a random walk in the land of higher for longer.
Source: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis; February 24, 2023.
The chart above shows how the pandemic disrupted a serene post financial crisis range for monthly core PCE largely between 0.0% to 0.2%. Since PCE’s breakout two years ago (which the Fed ignored as transitory), core PCE has effectively settled into a higher range from 0.2% to 0.6%. Inflation may have indeed peaked, but it remains stubbornly high in the aggregate. The eagerly anticipated pre-pandemic serenity remains as elusive as ever.
Higher for longer inflation aligns with the Federal Reserve’s insistence on maintaining restrictive monetary policy higher for longer. The stock market may finally be catching on to the notion of higher for longer for inflation. When the core Consumer Price Index (CPI) came in hotter than expected in the previous week, the S&P 500 (SPY) wavered from intraday highs to lows and even increased the next day. Sellers took over the next 5 of 6 trading days with today’s 1.0% loss seemingly confirming a change in sentiment.
The S&P 500’s loss would have been worse except traders decided to defend support at the 200-day moving average (DMA) (the blue line above). This important trend line separates the index from more churn and a continuation of selling back down to the bear market line (20% down from the all-time high).
The bond market sniffed out the hotter inflation environment ahead of the stock market. Bond yields have steadily risen all month. For example, the iShares 20+ Year Treasury Bond ETF (TLT) is down 5.8% month-to-date (lower TLT means higher yields). The hot PCE brought an abrupt end to a 2-day relief rally in TLT.
Of course, the inflation story does not end here. The recent experience with inflation surprises suggests inflation will continue to confound the over-confident. A humbled Federal Reserve seems validated in taking a “risk management” approach to monetary policy in this haze of uncertainty. Still, if monthly core PCE takes a fresh drop next month, I am guessing a chorus will resume the inflation dismissals. If monthly core PCE continues higher from here, I will ring fresh alarm bells. I am watching the bond market’s next moves for potential clues. Moreover, I cannot wait to hear what the Federal Reserve and Chair Jerome Powell have to say about these developments in next month’s meeting!
Be careful out there!
Kashkari Acknowledges the Fed’s Inflation Miss. Will the Fed Catch Easing Financial Conditions?Posted: January 30, 2023 Filed under: Automobiles, Bond market, Economy, Monetary Policy | Tags: Adjusted Financial Conditions Index, ANFCI, Federal Reserve, iShares 20+ Year Treasury Bond ETF, James Bullard, Neel Kashkari, TLT 2 Comments
At the beginning of the year, Neel Kashkari, President of the Minneapolis Federal Reserve, wrote a revealing piece titled “Why We Missed On Inflation, and Implications for Monetary Policy Going Forward.” The article is a worthwhile (and bit-sized) piece since it may be the first and only time any member of the Fed has attempted to confront this topic head-on. Recall that it was June, 2021 when the Fed first acknowledged a surprising increase and persistence in inflation pressures. However, Chair Jerome Powell implied that the inflation problem would go away on its own accord. It was St. Louis Federal Reserve President and CEO who raised a truly hawkish alarm bell. His colleagues took a lot longer to get on board.
Kashkari sums up the Fed’s collective miss as coming from an over-reliance on traditional Phillips-curve models. These models failed the Fed for this economic cycle:
“In these workhorse models, it is very difficult to generate high inflation: Either we need to assume a very tight labor market combined with nonlinear effects, or we must assume an unanchoring of inflation expectations. That’s it. From what I can tell, our models seem ill-equipped to handle a fundamentally different source of inflation, specifically, in this case, surge pricing inflation.”
No wonder it is easy to maintain a deflationary mindset. The Philips-curve models are biased against inflationary pressures.
Refreshingly, Kashkari is not willing to accept economic shocks as an excuse for missing the seriousness of inflation in this economic cycle. Instead, he cautions that such dismissals impede learning. Moreover, he claims that even a crystal ball on inflation shocks would not have pushed the Philips-curve models to raise an inflation alarm. Since Kashkari makes this claim without evidence, I hope that someone in the Fed is working on a related white paper to advance learning on this topic.
Kashkari went on to observe that the Fed’s policy framework focuses on the labor market and inflation expectations: “If we can deepen our analytical capabilities surrounding other sources and channels of inflation, then we might be able to incorporate whatever lessons we learn into our policy framework going forward.” Yet, in April 2022, I summarized two Fed studies that identified housing as a key source of the inflation problem. At the time, I assume these studies helped guide the Fed’s determination to finally start hiking rates. I do not know how to reconcile these studies with Kashkari’s claim, but I hope he finds his way to this work at some point.
Kashkari concludes by standing firmly behind today’s monetary policy. Without a sense of irony, Kashkari defended the current monetary tightening by using wage pressures as his example.
“One may ask why tightening monetary policy is the right response to what I described as surge pricing inflation. Unfortunately, the initial surge in inflation is leading to broader inflationary pressures that the Federal Reserve must control. For example, nominal wage growth has grown to 5 percent or more, which is inconsistent with our 2 percent inflation target given recent trend productivity growth. Monetary policy is the appropriate tool to bring the labor market back into balance.”
Kashkari is also not interested in cutting rates anytime soon: “consider cutting rates only once we are convinced inflation is well on its way back down to 2 percent.” Seemingly like everyone else on the Fed, he fears the echoes from the 1970s warning that it is all too easy to declare a premature victory over inflation.
Easing Financial Conditions
If bond yields are any indication, the bond market stopped worrying about increasing inflation pressures back in October and November. For example, the iShares 20+ Year Treasury Bond ETF (TLT) not only bottomed but also it rallied 15.5% in just three months (TLT moves inversely to bond yields). Accordingly, I am eager to see whether the next announcement on monetary policy calls out the bond market for prematurely facilitating an easing in financial conditions.
The iShares 20+ Year Treasury Bond ETF (TLT) achieved a higher low at the end of December. It is close to a breakout above tis 200-day moving average (DMA) (the blue line above) which would usher in a new phase of easing of financial conditions. Is the Fed ready for that to happen? (Source: TradingView.com)
The Chicago Federal Reserve’s Adjusted Financial Conditions Index has been consistently easing since a cycle high in October.
Be careful out there!
Full disclosure: no positions
Did Alan Blinder Suggest the Fed Should Have Done Nothing About Inflation?Posted: January 19, 2023 Filed under: Monetary Policy | Tags: Alan Blinder, Federal Reserve, Monetary Policy, PCE 6 Comments
Former Fed Governor and current Princeton Economics professor, Alan S. Blinder wrote an opinion piece in the Wall Street Journal that essentially implied the Federal Reserve need not have raised rates to battle inflation. In a piece with the click-worthy title “What if Inflation Suddenly Dropped and No One Noticed?“, Blinder makes the following claim:
“Was the rest of the stunning drop in inflation in 2022 due to the Fed’s interest-rate policy? Driving inflation down was certainly the central bank’s intent. But it defies credulity to think that interest-rate hikes that started only in March could have cut inflation appreciably by July. There is an argument that monetary policy works faster now than it used to—but not that fast.”
Blinder goes on to explain that relief from supply and energy shocks were the biggest drivers of plunging inflation. Going forward, he thinks that the current five month decline in inflation is “…still too short a time to declare victory,” but he gives no explanation as to why going forward further Fed rate hikes will matter for getting inflation down this last mile of the way. I would have expected Blinder to argue that the Fed has already over-corrected for inflation.
Chasing the Trend In Inflation
It is pretty well accepted that inflation peaked several months ago. However, when Blinder worries that “no one will notice” the drop in inflation, he is worried about the finer technical details of trends. He breaks out the difference between earlier and current inflation to show how the year-over-year rate blurs the story.
“…the CPI inflation rate over the past 12 months has been an alarming 7.1%. But the U.S. economy got there by averaging an appalling 10.6% annualized inflation rate over the first seven months and a mere 2.5% over the last five. The PCE price index tells a similar story, though a somewhat less dramatic one. The 5.5% inflation rate over the past 12 months came from a 7.8% rate over the first seven months followed by a 2.4% rate over the last five.”
Blinder acknowledges that using this more refined (I will call it less lagged) approach would have also warned the Fed much earlier about inflation in 2021. In fact, it was recent trends that made loud skeptics of the Fed’s reassurances about “transitory” inflation.
Regardless, there is little magic or revelation in this breakdown. Blinder is simply providing a more technical description of what happens when a metric that quantifies changes over time peaks: the earlier components of that measure are, on average, higher than the more current ones. The graph below of the PCE (personal consumption expenditures) excluding food and energy juxtaposes the monthly change (grey line and vertical axis on the left) in the PCE with the annual change (black line and vertical axis on the right) in the PCE.
Source: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis, January 19, 2023.
Note how the pre-pandemic stability in the monthly change supported stability in the annual change of the PCE. The annual change started to rise once the monthly changes started to rise to higher levels post-pandemic. The annual change reached a new, higher stability after the monthly changes stopped rising. Now, the monthly changes are finally producing a higher frequency of much lower numbers. Thus, the annual change looks like it has finally peaked. Stare hard enough, and you can even see the early makings of a declining trend.
Blinder worries that no one may notice the sudden drop in inflation. However, I suspect plenty of people have noticed the decline. There is a healthy collection of Fed critics and related folks who think the Fed over-reached after its first rate hike last March or May who are twisting the numbers every possible way to make the case that the inflation problem died a few months ago and/or the Fed has taken interest rates far too high, too fast. Again, because inflation has apparently peaked, it is easy to fathom that more recent inflation pressures are milder than earlier inflation pressures.
Where Is the Policy Implication?
Blinder’s WSJ piece avoided giving direct advice on monetary policy. However, he gave more clues in an interview with Marketplace. At the very end of the discussion, Blinder essentially said that the Fed should stop now, but they cannot do so because market’s will prematurely ease:
“The Fed is in a very ticklish position. They can’t be as frank as I just was with you. I could say anything, and I don’t move markets. If Jay Powell sneezes, he moves markets. It is too early to declare victory over inflation, it’s only six months. And that’s what Jay Powell or any of the Fed people would say if you had them on the radio. But I say it’s six months. Six months is not a week, six months is not two months. This is not a trivial length of time. I think it might take a year of this or, say, another six months to convince the Fed to declare victory. They’re not about to declare victory yet.”
Note how his advice here directly contradicts his caution in the WSJ piece that the timeframe for the inflation decline is too short to support victory laps. No wonder monetary policy can be so confusing.
Moreover, the Fed has been very clear about the metric it uses for the 2% inflation target: a year-over-year change that is demonstrably sustainable. The Fed cannot declare victory because the target as previously defined still sits out in the future. To suddenly change the timeframe to inflation over the last X months would undermine Fed credibility even more than the retreat from the “transitory” episode.
Ironically, with the Fed already effectively programming itself to end rate hikes in March, Blinder’s technical examination could be nearly moot…at least without specific policy prescriptions.
Be careful out there!
Bullard Ready to Declare Partial Victory Over InflationPosted: January 5, 2023 Filed under: Economy, Monetary Policy | Tags: Federal Reserve Bank of St. Louis, GDP, inflation expectations, James Bullard, labor market, Monetary Policy, S&P 500, SPY, unemployment 2 Comments
James Bullard, President and CEO of the St. Louis Federal Reserve, delivered a speech today to the CFA Society St. Louis. Bullard titled the speech “The Prospects for Disinflation in 2023.” Given Bullard defined disinflation as “a decrease in the rate of inflation toward the Fed’s 2% inflation target”, he could have more directly titled the speech “We Are Beating Inflation….But Don’t Celebrate Yet.” The essence of the speech suggested that the Federal Reserve can so far take some credit for a partial victory over inflation: “front-loaded Fed policy has helped keep market-based measures of inflation expectations relatively low.” However, that victory must be secured by staying the course to nudge the policy rate a little higher into the “sufficiently restrictive” zone. Critics who think the Fed uses too much discretion should appreciate the use of the Taylor rule to calculate the ultimate destination for monetary policy. Fed critics who think the Fed has gone too far should be relieved to see that the Fed is targeting the lowest possible Taylor-based rate and not the highest. (All charts copied from Bullard’s presentation).
As rates have risen, inflation expectations have declined sharply. Bullard offered the following chart to demonstrate the effectiveness of the Fed’s rush to front-load rate hikes.
Some people look at these expectations and conclude the Fed can stop before getting into the “sufficiently restrictive” zone. Some people might even conclude that Fed should start cutting rates. Most of those folks are probably focused on the stock market’s performance. Bullard instead is looking at the actual performance in the economy. GDP growth was unexpectedly strong in the second half of 2022. Even more importantly, the labor market remains very strong in aggregate as it glides through unprecedented territory. At least since 1980, the U.S. economy has never experienced such a wide gap between available jobs to the high side and available workers to the low side.
As long as this gap persists at such a magnitude, the Fed can feel comfortable about lifting rates into restrictive territory.
The Fed can declare partial victory since inflation expectations are back to previous norms. However, as Bullard noted consistently with the Fed’s messaging for months, “inflation remains too high.” If the Fed prematurely declares victory, the tightness of the labor market could become a source for reigniting inflation pressures, both real and expected.
Bullard’s words can generate out-sized market impacts. On this day, the market took Bullard’s caution pretty well. Bullard is still hawkish, but at least he is conceding some form of victory. The S&P 500’s (SPY) 1.2% loss is well within the volatility the index has experienced since it broke down below its 50-day moving average (DMA) in mid-December.
Be careful out there!
Full disclosure: no positions
On Marketplace, El-Erian Describes the Cost of A Late Start to Fighting InflationPosted: December 21, 2022 Filed under: Economy, Monetary Policy | Tags: Jerome Powell, Kai Ryssdal, Marketplace, Mohamed El-Erian, Monetary Policy 1 Comment
Mohamed El-Erian earned kudos on these pages when he pushed against 2021’s conventional wisdom of “transitory inflation” and insisted that the Fed needed to act to fight inflation. When too many thought that inflation would take care of itself and presented no threat to the economy, El-Erian was a solid inflation-fighting voice. So when he recently showed up to Marketplace for an interview, my ears naturally perked up.
El-Erian made several references to the tardiness of the Fed’s monetary tightening. Woven together, these quotes provide a key tenet of Fed critique and characterize the implications of being late to tightening.
“We know that, had they [the Federal Reserve] not fallen into this cognitive trap of inflation being transitory, had they acted earlier, they could have hiked into a growing economy. And they could have avoided what is one of the most front-loaded hiking cycles in history…
If you are late — and the Fed has been very late — you have no choice but to move really quickly. To make it specific, this Fed has increased interest rates by .75% four times in a row. That is a record that is almost unheard of, including during the ’70s and ’80s, when we had a much bigger inflation problem…
Even when they recognized, at the end of November last year, that inflation was not transitory, they didn’t move fast enough.”
I call the “cognitive trap” the earlier lethargy of deflationary thinking. The Fed fought and worried about deflation for so long that simple inertia nearly guaranteed the Fed would be slow to respond when real inflationary pressures appeared. Now the Fed is counting on a strong jobs market to provide political and economic cover for their mad scramble to catch up. I have yet to see anyone come to this conclusion as I have, but the proof could come in the Fed’s response to definitive evidence of a contraction in the jobs market. If the Fed is not done hiking by then, they will most likely stop hiking soon after the negative impact on the job market is obvious.
Kai Ryssdal thinks Powell admitted the Fed “blew it” in his May interview with Powell. I heard something different. The relevant quote from this interview tells me that Powell only acknowledged a small possibility that moving earlier would have generated better outcomes. However, the point is moot since the Fed would have only moved earlier with perfect information:
“I have said, and I will say again that, you know, if you had perfect hindsight you’d go back and it probably would have been better for us to have raised rates a little sooner. I’m not sure how much difference it would have made, but we have to make decisions in real time, based on what we know then, and we did the best we could. Now, we see the picture clearly and we’re determined to use our tools to get us back to price stability.”
I contend that if the Fed had implemented its risk management framework last year, that policy would have moved the Fed to start hiking rates sooner. Risk management calculations could have informed the Fed that even with the low risk assigned to being wrong about “transitory”, the cost of being wrong was great enough to make earlier rate hikes worthwhile.
Six months ago, I referenced the concept of “persistently elevated, unactionable inflation.” El-Erian talked about the potential for sticky inflation. He described the possibility this way: “…because the Fed waited for so long, the inflation challenge has shifted from the interest rate-sensitive sectors to sectors that are less interest rate-sensitive: services and wages.” Assuming El-Erian is correct, then as the economy grinds into a slowdown next year, the Fed is likely to concede to an economy with inflation above target. El-Erian makes the following supportive claim:
“…if they were formulating the inflation target today, I doubt it will be 2%. I think most people agree it would be higher than that…So the best we can hope for is, by the middle of next year, we’ve gotten to stable inflation of about 3% to 4%. They keep on telling us that they’re gonna pursue 2% in the future, and society learns to live with a stable inflation rate that is not 2%.”
Considering what the economy has experienced for almost three years, some stability might feel like a welcome change.
Before careful out there! (I highly recommend reading or listening to the full interview with El-Erian)
Lennar Corporation: How the Fed Is Cooling Inflation In the Housing MarketPosted: December 20, 2022 Filed under: earnings reports, Economy, Housing | Tags: home builders, housing market, LEN, Lennar Corporation, supply chain Leave a comment
Plenty of evidence exists that the Federal Reserve’s fight against inflation is working. Home builder Lennar Corporation (LEN) recently provided a vivid example of how the Fed’s rate hikes have forced the housing market to correct and push back against inflationary pressures. Deflationary forces are now at work in the system.
In last week’s Q4 earnings conference call, Lennar described an important chain of events that are underway. The company has been proactive in getting ahead of slowing demand and rising rates by purposely reducing margins to accommodate price reductions and incentives on a community-by-community basis. (The following housing markets are Lennar’s most problematic: Orlando, Pensacola, Northern Alabama, Austin, Phoenix, Utah, Reno, and Portland). In turn, Lennar is using its size and market dominance to force concessions from its supply chain. For example:
“We have very strong relationships with our trade partners. We have demonstrated to them that we have taken the first step by lowering sales prices to drive sales, and they understand this and understand the dynamic of labor availability as overall starts slow and they’re working closely with us to lower their prices…As with our trade partners, our land partners or sellers understand that we are maintaining volume and increasing market share while taking the first hit to our margin. They will need to work together and participate or we’ll need to move on.”
Lennar was even more direct in describing its advantage when inferring that the supply chain needs the work that Lennar can provide by keeping sales volumes flowing:
“…you really can’t underestimate the leverage that we get in working with our trade partners as things slow down across the board. People are looking for work. If we’re going to be the ones out there to do — starting homes, we’re going to get cost concessions, bringing cost concessions from our trade partners, from our land partners, and we’re just going to continue”
The industry-wide slowdown in housing starts has “sped up the availability of labor and materials for Lennar.” As a result, the company can use its dominant market position to extract lower costs out of the supply chain. Scarcity in the supply chain is easing and inflationary pressures are easing. Smaller builders are likely suffering the most from this change in dynamics.
Interestingly, LEN jumped 3.8% to a 10-month closing high in response to what was a surprisingly bullish earnings report considering the market environment. This buying was particularly impressive given the post-Fed sell-off underway in the stock market. It looked like another win for the seasonally strong period for home builder stocks. However, since then, gravity has slowly exacted its toll as interest rates have started to climb again. That post-earnings celebration is completely reversed now. The chart below marks earnings with a dashed vertical line labelled “E” in the bottom axis.
An irony awaits the economy on the other side of this housing reality check. With builders slowing down starts in parallel with housing demand postponed by punishing mortgage rates, an economic recovery will deliver a rush that will expose new market dysfunctions. Home prices could quickly turn around as eager buyers once again scramble for limited inventory. The major builders will continue to move slowly in adding supply to the market. The intense rationalization of the housing market will keep “normalization” out of reach in the most attractive housing markets.
In the meantime, waning inflationary pressures should at least benefit more participants than runaway inflation.
Be careful out there!
Full disclosure: no position
Median CPI May Be A Window on Fed’s Inflation CautionPosted: December 18, 2022 Filed under: Bond market, Economy, Monetary Policy | Tags: 16 percent trimmed-mean CPI, Federal Reserve, Federal Reserve Bank of Cleveland, iShares 20+ Year Treasury Bond ETF, Jerome Powell, median CPI, TLT 1 Comment
Last week, the Federal Reserve disappointed markets once again with its refusal to acknowledge the market’s belief in the end of the inflation threat. The opening statement for December’s decision on monetary policy delivered the familiar refrain: “The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” During the press conference, Chair Powell further emphasized that the Fed has yet to see substantial evidence that inflation will continue to come down in a sustained way. So while the Fed is slowing the pace of rate hikes, the Fed will continue hiking past the market’s peak rate expectations. Powell even rebuffed once again the notion that the Fed will cut rates next year. So if inflation has peaked, why is the Fed so “stubborn”? The dynamics in median CPI may be a window on the Fed’s inflation caution.
Every month, financial markets receive a bevy of inflation reports. The Federal Reserve watches all of them as is clear from the various research papers and metrics the various Federal Reserve banks produce. The Federal Reserve Bank of Cleveland produces a monthly report on the median CPI and the 16 percent trimmed-mean CPI. Per the definition provided with the report:
“Median CPI is the one-month inflation rate of the component whose expenditure weight is in the 50th percentile of price changes. 16 percent trimmed-mean CPI is a weighted average of one-month inflation rates of components whose expenditure weights fall below the 92nd percentile and above the 8th percentile of price changes.”
Why use the median CPI and the 16% trimmed-mean CPI? The Cleveland Fed explains: “By omitting outliers (small and large price changes) and focusing on the interior of the distribution of price changes, the median CPI and the 16 percent trimmed-mean CPI can provide a better signal of the underlying inflation trend than either the all-items CPI or the CPI excluding food and energy (also known as core CPI).”
This effective smoothing of the inflation dynamics produces a lag in the peak for inflation and shows almost no indication that inflation is ready to come down in the sustained fashion the Fed wants to see. In the chart below, the yellow line is the median CPI, and the greyish blue line is the 16% trimmed-mean CPI. For November, the order from top to bottom is the (headline) CPI, median CPI, 16% trimmed-mean CPI, and the core CPI.
The trend is NOT yet down. If these were stock charts, I would even argue an uptrend remains in place.
The 16% trimmed-mean CPI looks like it has likely peaked, but the topping pattern lacks the double-topping that makes the peak in core CPI look so convincing. The median CPI is the worst news for those who think the inflation threat is already over: this measure is just now plateauing after streaking straight upward since late last year. Sure, there are all sorts of forward-looking measures that the Fed sees as confirming a peak in inflation, but there is little saying the inflationary pressures are going to come down sufficiently and conclusively. The Fed’s risk management framework thus mandates that the Fed proceed with caution. The magnitude of decline that mollifies the Fed remains anyone’s guess. Meanwhile, interest rates are still fighting the Fed and likely more focused on the prospects for a 2023 recession.
The iShares 20+ Year Treasury Bond ETF (TLT) is hovering at levels last seen three months ago. TLT looks like it bottomed out in October/November. Source: TradingView.com
Be careful out there!
Full disclosure: no related positions
The Fed Plants A Flag On Peak Inflation and An Economic Soft LandingPosted: December 3, 2022 Filed under: Bond market, Economy, Jobs, Monetary Policy | Tags: federal funds rate, Federal Reserve, inverted yield curve, Monetary Policy, proxy funds rate, recession, S&P 500, SPY 5 Comments
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. (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. (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.
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 InflationPosted: December 1, 2022 Filed under: Bond market, Economy, Jobs, Monetary Policy | Tags: Brookings Institution, Fed Fund Futures, Federal Reserve, Jerome Powell, Monetary Policy, S&P 500, SPY 5 Comments
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. (Source: TradingView.com)
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 YouPosted: November 14, 2022 Filed under: Central bank, Currencies, Economy, Monetary Policy, Switzerland | Tags: FXF, Invesco CurrencyShares Swiss Franc Trust, Monetary Policy, SNB, Swiss franc, Swiss National Bank, Thomas Jordan, USD/CHF 1 Comment
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 TradingView.com 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.
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 PsychologyPosted: October 17, 2022 Filed under: Central bank, Economy | Tags: fed funds rate, Federal Reserve, inflation expectations, interest rate, Monetary Policy, Richard Corbin, S&P 500, SPY, University of Michigan surveys of consumers 1 Comment
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 LetterPosted: October 11, 2022 Filed under: Bond market, Central bank, Economy, Monetary Policy | Tags: ARK Innovation ETF, ARKK, Cathie Wood, deflation, Federal Reserve, inverted yield curve, Monetary Policy 1 Comment
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.
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.
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 RatesPosted: October 6, 2022 Filed under: commodities, Economy, iron ore, Monetary Policy, oil, Salaries | Tags: BHP, BHP Group, Fed Fund Futures, Federal Reserve, Mary Daly, Monetary Policy, real wages, UGA, United States Gasoline Fund 4 Comments
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.
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 PosturingPosted: September 18, 2022 Filed under: Economy, Monetary Policy | Tags: CME FedWatch Tool, Fed Fund Futures, New York Federal Reserve, S&P 500, SPY, Survey of Consumer Expectations Leave a comment
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 InflationPosted: August 2, 2022 Filed under: Australia, CPI, Currencies, Monetary Policy | Tags: AUD/JPY, AUD/USD, FXA, RBA, Reserve Bank of Australia, Stephen Koukoulas Leave a comment
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.
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…MaybePosted: July 19, 2022 Filed under: earnings reports, Financials | Tags: Goldman Sachs, GS Leave a comment
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. (Source: TradingView.com)
Be careful out there!
Full disclosure: no positions
So Much For Peak InflationPosted: July 13, 2022 Filed under: CPI, Economy | Tags: Brian Deese, Carl Quintanilla, CNBC, CPI, PEP, PepsiCo Inc 1 Comment
“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 InflationPosted: July 3, 2022 Filed under: Agriculture, Bond market, commodities, iron ore, Materials, Monetary Policy, Steel | Tags: 30-year fixed rate mortgage, BHP, BHP Group Limited, corn, FCX, Federal Reserve, Freeport McMoRan, lumber, RIO, Rio Tinto, TIPS, Treasury Inflation-Protected Securities, XME 5 Comments
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).
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 TradingView.com). 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.
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.
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).
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 RatesPosted: June 17, 2022 Filed under: Economy, Monetary Policy, Switzerland | Tags: Monetary Policy, SNB, Swiss franc, Swiss National Bank, USD/CHF Leave a comment
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!