Fed’s Bostic: Still Comfortable Leaning Into Tight Labor Markets

I have argued for a while that as long as the labor market remains tight with low unemployment, the Federal Reserve will press as far as it dares on its cycle of monetary tightening. Raphael Bostic, CEO of the Atlanta Federal Reserve (and currently a non-voting member of the Federal Open Market Committee), confirmed that strategy during a recent interview with Marketplace.

Don’t Come Crying to the Fed Anytime Soon

Bostic definitively stated that the Fed is so determined to press against inflation that it will likely turn a deaf ear to those who will ask for easier monetary conditions the moment the labor market delivers bad news. Emphasis mine:

“You know, as we get further into inflation getting, closer to our target, I’m expecting we’re going to see stresses in labor markets. We’ve not really seen that. And when that starts to happen, people are going to be looking to us to try to do something about that as well, and maybe turn away from our focus on inflation. But we can’t do that, because failing in getting the inflation back to the 2% target will be much more problematic for the economy. And so as people start to call out for action to provide relief in labor markets, I think what we’re going to have to do is just stay laser focused on the fact that, you know, our employment mandate goal, we are very, very close to that right now. And we’re not close to that in inflation. So we have to stay focused on inflation.”

The bad news for the labor market has been long anticipated and stubbornly absent for the people who keep expecting a recession at every turn of the calendar. This “lagging indicator” of economic health just keeps chugging along. Even a recent uptick in initial unemployment claims above 240,000 fizzled out before the “I told you so’s” could drape the economic headlines. The 251,000 in weekly initial claims from January, 2022 stands as the latest high. For now, initial claims continues to tell the same message week after week after week: the Fed has room to hike if inflation remains an issue. Rate cuts are certainly nowhere on the horizon from this vantage point.

Source: U.S. Employment and Training Administration, Initial Claims [ICSA], retrieved from FRED, Federal Reserve Bank of St. Louis; May 25, 2023.

Given this data and Bostic’s determination to ignore anyone who wants the Fed to cut rates into an inflationary environment, I understand Bostic’s best guess target for rate cuts set a year or more out from now.

“My best case is that we won’t be thinking about a cut until well into 2024. And, you know, inflation is just double what our target is by just about every measure. I don’t see scenarios where the economy is going to evolve in a way such that inflation gets close enough to our target where we might contemplate any kind of cut.”

As of the time of writing, Fed fund futures have acquiesced to the likelihood of another rate hike by July. However, they still eagerly anticipate rate cuts as soon as November. By the time Bostic guesses the Fed will think about cuts, the futures think the Fed will have 6 or 7 rate cuts in the books. The persistently wide gulf between Fed and market expectations on rate policy remains one of the more remarkable features of today’s financial markets.

Fresh Wind for the U.S. Dollar

The market’s push for another rate hike by July has helped the U.S. dollar regain momentum. Strength particularly against the euro and the Japanese yen has the dollar index (DXY) bouncing off its lows for the year. I am riding this momentum as long as it holds up. If the rally continues from here, I expect fresh resistance at the year’s high which should also coincide at the time with critical resistance from the 200-day moving average (DMA) (the bluish line below).

Source: TradingView.com

Be careful out there!

Full disclosure: net long the U.S. dollar


A Golden Inflation Conundrum

Last week, SPDR Gold Shares (GLD) rallied on weak inflation news and pulled back on strong inflation news. The gap up in GLD followed by a gap down created the dreaded “abandoned baby top.” This technical pattern typically signals the end of a rally. What gives with this golden inflation conundrum?

SPDR Gold Shares (GLD) printed a technical topping pattern amid mixed inflation news, but it is trying to hold uptrending support at the 20-day moving average (DMA)

The Conundrum

The current inflationary cycle could be ending, at least in North America. For example, the Bank of Canada (BoC) showed inflation data with a steeply descending trend ending with a near perfect landing at the Bank’s 2% target in late 2024.

Here in the U.S. plenty of pundits have declared inflation a non-threat ever since the Federal Reserve finally got serious about it. Cathie Wood has been one popular critic of the Fed’s inflation concerns. The disbelievers received more confirming evidence when the latest producer price index told a disinflationary story. A slightly weaker than expected inflation reading from the March Producer Price Index (PPI) generated cheer in stocks given the implication for looser monetary policy. Since producer prices sit upstream from final goods prices, PPI can be a leading indicator of future prices.

Gold also celebrated the soft inflation numbers; GLD gained 1.4%. This reaction represents the upside of the golden inflation conundrum. Gold bugs suspect that the seeds of inflationary pressures remain well-grounded in the economy. I agree with them. A relaxed Fed is a potential catalyst for rewatering the garden of growing prices, especially if labor markets remain tight. Thus, the prospect of a relaxed Fed supports higher gold prices.

The downside of the golden inflation conundrum can come on stronger inflation signals because they support an aggressive, inflation-fighting Fed. GLD went into retreat in the wake of a surprising surge in consumer expectations for inflation next year from 3.6% in March to 4.6% in April. This reading from the University of Michigan’s surveys of consumers was last this high in November, 2022. Even if this move coincided with the jump in gas prices, surges in inflation expectations are sure to encourage the Fed to stay on message. As it happened, the market got a timely dose of messaging from Governor Christopher J. Waller the same day.

The Fed Stays On Message

In the wake of the economic data, Governor Christopher J. Waller spoke at the Graybar National Training Conference in San Antonio, Texas. Waller reiterated the all too familiar refrain “inflation remains much too high.” He provided the following cautionary assessment of inflation (emphasis mine):

“Inflation moderated in the second half of 2022, but that progress more or less stalled toward the end of the year…On April 12, we got consumer price index (CPI) inflation data for March, and it was another month of mixed news…Core inflation, which strips out food and energy prices, is a good guide to future inflation, and that measure came in at around 0.4 percent in March, which translates to an annual rate of 4.6 percent if it were to persist. It was the fourth month in a row with core inflation at 0.4 percent or higher. Since December of 2021, core inflation has basically moved sideways with no apparent downward movement. So, despite some encouraging news on a slowing in housing costs, core inflation does not show much improvement and remains far above our 2 percent inflation target.

Whether you measure inflation using the CPI or the Fed’s preferred measure of personal consumption expenditures, it is still much too high and so my job is not done. I interpret these data as indicating that we haven’t made much progress on our inflation goal, which leaves me at about the same place on the economic outlook that I was at the last FOMC meeting, and on the same path for monetary policy. Because financial conditions have not significantly tightened, the labor market continues to be strong and quite tight, and inflation is far above target, so monetary policy needs to be tightened further. How much further will depend on incoming data on inflation, the real economy, and the extent of tightening credit conditions.”

With the Fed’s next decision on monetary policy just two weeks away, Waller’s words suggest that the Fed could raise rates yet again. The odds are low of getting a disinflationary signal strong enough to counter Waller’s observations. Thus, I think GLD will struggle to invalidate the technical topping pattern for the time-being.

The Trade

The golden inflation conundrum leaves GLD in a contrary place. In the short-term, GLD’s best chances lie with soft inflation numbers. Indeed, GLD bottomed shortly after the market bottomed in October when market participants concluded that inflation had finally peaked. Inflation’s peak does not equal the Fed’s inflation target; the Fed has gone to great lengths to issue these reminders. Yet, beyond day-to-day volatility, the market has overall chosen to fight the Fed’s hawkishness ever since October. Volatility is even back to levels last seen at the start of trading in 2022 despite the linger crisis in regional banking.

Where volatility is poorly positioned, GLD is well-positioned. From the looming battle over the U.S. debt ceiling to the prospect of the Fed standing down later this year to geo-political risks, there are enough reasons to stay bullish on GLD. I am back to trading around my core position. I took profits on half my call spreads last week. My remaining half is set to expire in September. I want plenty of runway for the gold-positive catalysts to work their way through the golden inflation conundrum.

Be careful out there!

Full disclosure: long GLD shares and call spread

Kashkari Acknowledges the Fed’s Inflation Miss. Will the Fed Catch Easing Financial Conditions?

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’s Confessional

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?

The Claim

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 Inflation

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 Inflation

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.

Sticky Inflation

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)

Median CPI May Be A Window on Fed’s Inflation Caution

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 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: 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 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 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.

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

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: TradingView.com)

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

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 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.

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!

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