Reserve Bank of Australia Revives the Ghost of Inflation Past

After the Reserve Bank of Australia (RBA) decided to leave its interest rates unchanged last month, the Australian dollar sold off for a week against the U.S. dollar. The decline reversed the small rally leading into the decision on monetary policy. AUD/USD enjoyed a small rebound going into the May decision on monetary policy and then jumped after the RBA threw markets for a loop by hiking interest rates again. More importantly, the RBA quickly revived the ghost of inflation past. The RBA undermined any assumptions that it would be content to watch inflation try to guide itself from 7% down to the 2% to 3% target range. The previous pause in rate hikes did not seal the deal on the fight against inflation.

The 15-minute chart of AUD/USD shows how traders rushed to buy in the wake of a surprise rate hike. The enthusiasm peaked within 3 hours. (Source: TradingView)

The RBA acknowledged that “inflation in Australia has passed its peak.” However, inflation at 7% is too high and “…while the recent data showed a welcome decline in inflation, the central forecast remains that it takes a couple of years before inflation returns to the top of the target range.” This inflation horizon means the RBA could intermittently hike rates for quite some time as it scours the landscape for smoldering embers of inflation.

The current problem is in services price inflation. The U.S. also faces this challenge. Indeed, he RBA referenced global commonality in explaining the sources of stubborn highly inflation (emphasis mine):

“Goods price inflation is clearly slowing due to a better balance of supply and demand following the resolution of the pandemic disruptions. But services price inflation is still very high and broadly based and the experience overseas points to upside risks. Unit labour costs are also rising briskly, with productivity growth remaining subdued…Wages growth has picked up in response to the tight labour market and high inflation.”

The RBA further explained that the rate hike should firmly anchor medium-term inflation expectations. Tightening monetary policy is acting like an insurance policy against higher inflation expectations contributing “to larger increases in both prices and wages, especially given the limited spare capacity in the economy and the historically low rate of unemployment.” Unemployment in Australia remains at a 50-year low. Thus, the RBA has plenty of room to continue tightening as needed…at least for now. The RBA acknowledged the challenge ahead in avoiding a recession while it tightens monetary policy:  “the path to achieving a soft landing remains a narrow one.”

The RBA concluded the May statement on monetary policy just as it ended the previous statement: “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe, but that will depend upon how the economy and inflation evolve.” In other words, the market will need to stay on its toes.

The Trade

The intraday surge in AUD/USD was not enough to punch the currency pair through important resistance on the daily level. AUD/USD remains trapped underneath resistance from all three major trendlines: the 20-day moving average (DMA) (dashed line), 50DMA (red line), and the 200DMA (blue line). Thus, I am neutral on AUD/USD until at least after I see how the market responds to the Federal Reserve’s turn to announce monetary policy.

AUD/USD has been stuck in a range for two months. Resistance from the 20DMA, 50DMA, and 200DMA are now capping upside. (Source: TradingView)

The Australian dollar versus the Japanese yen (AUD/JPY) is much more interesting, especially with the Australian dollar holding a significant yield advantage. The Japanese yen is suffering a fresh bout of weakness because the new governor of the Bank of Japan confirmed that he has little interest in tightening policy from ultra low rates. The double dose of yen weakness and Australian dollar strength hurled AUD/JPY right into overhead resistance at the 200DMA. A rush to the “safety” of the yen in the wake of fresh selling in the U.S.’s regional banks help send AUD/JPY in reverse. Still, while the 200DMA held as resistance, AUD/JPY is now making higher highs and higher lows with the 20DMA in an uptrend. The current 50DMA breakout could hold given this fresh momentum. (Recall that a bullish AUD/JPY has bullish implications for the stock market).

Overall, with the RBA on a path that could include higher rates for some time, I like buying the Australian dollar on dips on the assumption it has likely bottomed against the U.S. dollar and the Japanese yen. I am currently (re)accumulating AUD/JPY on this pullback in anticipation of an eventual retest of 200DMA resistance.

AUD/JPY has traded in a well-defined range all year. The latest uptrend is the latest opportunity to build enough momentum to break out. (Source: TradingView)

Be careful out there!

Full disclosure: long AUD/JPY, long FXA

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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


Don’t Blame the Fed: The Fed Gives Us What We Want

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.

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.

Source: TradingView.com

Be careful out there!

Full disclosure: long GLD


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)


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


Inflation Expectations and Inflationary Psychology

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Be careful out there!

Full disclosure: short SPY put spread


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

A Letter or A Plea?

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

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

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

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

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


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


The Federal Reserve Fears On-Going Inflationary Pressures from Rents

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

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

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

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

Be careful out there!

Full disclosure: no positions


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

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

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

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

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

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

Be careful out there!

Full disclosure: long FXY put options


The Fed Asks “What Inflation?”

Last week, headlines and pundits were hot and bothered about the potential for the Federal Reserve to fall behind the curve on inflation. While my on-going assumption is that the Fed will indeed chose much higher inflation rather than risk ending the economic recovery with higher rates, I think the current hand-wringing by some is premature. In fact, it seems more the result of either boredom with the Fed’s business as usual policy stance and/or the anxiety on the part of some stock market bears looking for any kind of catalyst to shake the market out of its low volatility slumber

I was so surprised at all the hand-wringing over a “business as usual” policy statement that I rolled the tape on the press conference. I was wondering what I missed, I actually listened to the conference call a second time (yes, it was painful). The experience made me even more convinced the market over-reacted just as much as it did when Yellen carelessly suggested rates might increase earlier than the late 2015 market projection.

Recent inflation numbers apparently increased expectations that the Fed might show a more hawkish tone. This is reflected best in the first question of the press conference from Steve Liesman of CNBC:

“Is every reason to expect, Madam Chair, that the PCE inflation rate, which is followed by the Fed, looks likely to exceed your 2016 consensus forecast next week? Does this suggest that the Federal Reserve is behind the curve on inflation? And what tolerance is there for higher inflation at the Federal Reserve? And if it’s above the 2 percent target, then how is that not kind of blowing through a target the same way you blew through the six and a half percent unemployment target in that they become these soft targets?”

 

This was a leading question, especially considering that Yellen made it very plain in her introduction that the inflation readings remain benign. Moreover, long-term expectations for inflation remain tame (also see the Fed’s latest projections). Most importantly, the year-over-year change in the PCE, the Personal Consumption Expenditure, reached the 2.0% target in early 2012 only to quickly plunge from there. Not only might it be premature to project a 2% reading for next week’s release, but there is nothing to suggest that this time is different. The Federal Reserve has the least control over the non-core prices of food and energy, so the escalation of violence and turmoil in Iraq is definitely not the kind of event that the Fed would try to offset with monetary policy.

 

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The Fed still can’t tease the market into sustaining pre-recession inflation levels…
Source: St. Louis Federal Reserve

Perhap’s Yellen’s poor response ignited the flames of disappointment. Yellen did not address PCE directly and instead talked about the noise in the Consumer Price Index (CPI) while reiterating the Fed’s standard guidance on inflation:

“So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it’s–the data that we’re seeing is noisy. I think it’s important to remember that broadly speaking, inflation is evolving in line with the committee’s expectations. The committee it has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.”

Ironically, Yellen could have just pointed to the longer-term trend in the CPI. This view dominates any shorter-term noise….

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The overall trend on CPI continues to point downward
Source: St. Louis Federal Reserve

The most bizarre part of the buzz on the Fed’s supposed willingness to ignore inflation is that Yellen re-affirmed, re-emphasized that the Fed is all about meeting its price target. It will not tolerate deviations in EITHER direction for long:

“…we would not willingly see a prolonged period in which inflation persistently runs below our objective or above our objective and that remains true. So that hasn’t changed at all in terms of the committee’s tolerance for permanent deviations from our objective.”

This was Yellen’s response to Liesman asking about the Fed’s tolerance for higher-than-target inflation.

I feel irony in my skepticism about a Fed ignoring a budding inflation threat: this is the core scenario that has kept me long-term in the gold (GLD) and silver (SLV) trades. My thesis/assumption back in 2009/2010 was that the Federal Reserve would be extremely reluctant to tighten policy even as the economy strengthened out of fear that rate hikes would quickly kill the economy. By the time the Fed was ready to hike rates, the “inflation genie” would already be out the bottle. Granted, I am not nearly as rabid about this view, especially since I have come to appreciate the deep entrenchment of the lingering post-recession deflationist psychology in the economy.

 So, overall, I am very skeptical that this episode is the long-awaited lift-off of inflation and a lagging Fed. I actually think the Fed is right to look through the current “warming” in inflation readings, and I think it will find vindication just as the Bank of England did during a similar episode under former Governor Mervyn King. When the Fed asks “what inflation”, I find myself surprisingly agreeing for now…

To me, the data do not support the notion that broad-based inflation is taking hold in the economy. We do not even have wage pressures, not to mention all the slack that remains in the economy as evidenced in part by extremely low levels of housing production. Just do a web search or read mainstream financial magazines to see anecdotally how many people are still worried about the sustainability of the so far very weak housing recovery. I find it hard to believe we will get strong inflation with all this weakness and deflationary fears. On the commodity side, copper and iron ore have experienced major price declines in recent months that also fly in the face of any kind of sustained inflationary pressure in the economy.

Full disclosure: long GLD, SLV.


The UK’s CPI inflation to remain stubbornly high for the next two years

On February 7th, The Monetary Policy Committee (MPC) of the Bank of England (BoE) decided to leave interest rates at the rock bottom rate of 0.5%. In doing so, the MPC acknowledged that it was assuming that the current stubbornly high inflation would eventually return to the target 2%. The MPC is expecting productivity gains and the reduction in external price pressures to do the trick.

“Inflation has remained stubbornly above the 2% target. Despite subdued pay growth, weak productivity has meant no corresponding fall in domestic cost pressures. And increases in university tuition fees and domestic energy bills, largely resulting from administrative decisions rather than market forces, have added to inflation more recently. CPI inflation is likely to rise further in the near term and may remain above the 2% target for the next two years, in part reflecting a persistent inflationary impact both from administered and regulated prices and the recent decline in sterling. But inflation is expected to fall back to around the target thereafter, as a gradual revival in productivity growth dampens increases in domestic costs and external price pressures fade.”

I took particular interest in the claim that external price pressures will fade. To do so, the global economy would have to remain weak. If so, then it is unlikely that growth in the UK will fare much better, even at the projected “slow but sustained” pace. The other possibility is that the British pound or sterling – CurrencyShares British Pound Sterling Trust (FXB) – appreciates enough that external prices go back down. If so, then Mervyn King’s hopes of rebalancing the economy with a reduction in demand for imports and an increase in exports surely will not be realized.

Adding to this conundrum for the UK economy is the stubborn persistence of weak economic growth (mainly flat) along with strong employment growth. The UK economy is getting less and less productive and thus less and less capable of offsetting inflationary pressures. This is a dynamic that I will be watching ever more closely given the BoE projects a two-year horizon over which the economy will continue to suffer high inflation and weak economic growth (aka stagflation). The implication for the currency is mixed, and I continue to expect “more of the same” for the pound.


Bank of England Governor King continues to bet on inflation taking care of itself

On June 15, Bank of England Governor Mervyn King spoke at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House. The speech covered very familiar themes for King and the Bank of England.

King begins by acknowledging the squeeze on the current economy:

“The challenge facing monetary policy is obvious – the combination of high consumer price inflation and weak economic growth. Both of these might seem surprising given the large amount of spare capacity in the economy. But the rise in world energy and other commodity prices, and the need to reduce both the external and budget deficits, are squeezing real living standards, pushing up on consumer price inflation and slowing domestic consumption.”

Over the years, King has consistently hammered on the theme of rebalancing in the UK’s economy: a transition away from domestic consumption and toward exports and the business investment required to support this shift. King indicated that the rebalancing underway will continue for several more years. This process has necessitated the devaluation of the currency. Interestingly, King cleverly attributes the devaluation to market forces while indicating the Monetary Policy Committee (MPC) chose not to counter-act the pressures on the currency:

“A necessary precondition for that rebalancing was a fall in the real exchange rate. Markets anticipated that need. The nominal effective sterling exchange rate fell by around 25% between the start of the crisis in 2007 and the beginning of 2009, since when it has been broadly stable…

…We could have raised Bank Rate significantly so that inflation today would be closer to the target. But that would not have prevented the squeeze on living standards arising from higher oil and commodity prices and the measures necessary to reduce our twin deficits. And it would have meant a weaker recovery, or even further falls in output…”

In other words, the MPC decided to focus on the implications of a weak economy over the implications of high inflation, judging the former to be the greater threat. In doing so, King has frequently noted that today’s high inflation is temporary, thus rationalizing on-going accomodative monetary policy and low interest rates in the face of high inflation. The primary blame for high inflation has shifted from hikes in taxes (the Value Added Tax or VAT) to commodity and energy prices, both presumably out of the control of monetary policy. Internally, conditions do not exist for sustaining “domestically generated” inflation:

“So far, subdued rates of increase in average earnings, as well as remarkably – some might say disturbingly – low growth rates of broad money have provided strong signals that inflation will fall back in due course. Banks are still contracting balance sheets and reducing leverage. Spreads between Bank Rate and the interest rates charged to many borrowers remain at unprecedentedly high levels, if indeed borrowers are able to access credit at all.”

King really caught my attention when he provided two key conditions that would actually compel rate hikes:

  • A pickup in domestically generated inflation
  • A contraction in the spreads between Bank Rate and the interest rates charged to many borrowers

Given the dour outlook for the economy and an on-going reblancing in the economy, I continue to assume that rate hikes in the UK are somewhere off in a very distant future. King has proven quite adapt in coming up with reasons for maintaining loose monetary policy, and I continue to see strong evidence that he is reluctant to tighten for fear it could upset the rebalancing he so deeply desires. Indeed, King notes that there is no way to tell when the MPC may hike rates:

“Uncertainty inevitably surrounds both the speed of the rebalancing and the impact of today’s consumer price inflation on tomorrow’s domestically generated inflation. So it is simply impossible to know now at what point monetary tightening will begin.”