Think inflation will definitely be stickier for a few reasons. Some outside Fed control.
1) Oil/NG pass through.
Seeing end of first round now as oil stabilizes around $100/bbl with meaningful gyrations. BUT NG still moving upward as US converges towards Europe and Asian levels. Energy prices cascade through to goods prices over time as manufacturers usually cannot capture cost increases 1:1 and recoup losses/margin compression over month to years. NG prices will be especially pernicious as it feeds through into fertilizer then food, chemicals, and a host of other goods.
2) Russia/Ukraine offline.
Beyong oil/NG impact, this will have major repercussions for wheat, corn, seed oils and fertilizer supplies. Have only begun to see impact on those in Africa, Mideast, Southeast Asia who rely on supply from R/U. Food calories will see inflation in coming years. Fed can do nothing about this.
3) Supply line shortages from China.
Big wildcard as they continue to address Covid. Hear wild stories from friends in electronics industries about lockdowns and people living in their Chinese plants. People essentially isolating to keep production going. One case leads to outbreak and shutdown of production lines. Employees won't leave plant as fear of contracting virus, and not being allowed to return to job.
4) Rent/OER rent increases are serially correlated and can take years for price appreciation to flow through.
My mortgage has 9 years left at 2.5% interest. My taxes go up, but my ownership cost fixed for years. Rising mortgages do essentially increase cost for new home purchasers barring a (large) offsetting price decline in the house purchase price. Rents can lag for a while - In markets where HPA has been extreme, landlords may not be able to pass through 1:1 contemporaneously without losing tenants leading to lower but persistent YoY rent increases.
5) Fed may have less impact further out the YC than anticipated.
Long US rates tied to European and Japanese rates. Bund rates following US rates up but to a diminished degree. JGB's staying stubbornly low, but crashing the Yen. Borrowing is a GLOBAL market. Look back on the degree of curve inversion Volker needed to bring down inflation in the early 80's. Don't think that the Fed has the stones to go there.
I do believe if you are right though the Fed won't have much of a choice - losing credibility for a Central Bank is even worse than a serious reversal in the wealth effect.
Hi Alf. Great article. I have re-read it a couple times this week because I think it is the core predictor of this market and our situation. It does boil down to credibility.
In fact the "sticky so far" has destroyed "transitory" completely of course, which damaged credibility. Actually 3 credibilities, 1) their mischaracterization of inflation expectations 2) the required U-turn in actions that were severely delayed, and now 3) not guiding sufficiently on how hard (hard-ish)a landing is to come.
So then they will reverse the reversal at say 5% inflation (not the stated 2%) for the sake of unemployment or a recession? Just abandon inflation targets altogether? That would be credibility annihilation.
The above comment about not having the "stones" proves they have lost a lot of credibility already.
As always Alf great post, you should definitely publish more often!
I recall that just half year ago many market commentators were wondering what is the actual 'fed put strike' number after which they would withdraw their hawkish tone. Well 20% lower on sp500 it is still not there :)
Maybe this time they will use unemployment rate to adjust their policies back to QE (is it even possible with current inflationary/staglationary environment?
I wonder who will get caught in 2022 "lehmann moment". Will it be some sp500 company, some leveraged hedge fund or maybe even some country from EM bracket?
Anyone remembers insider trading activities done by Powell buddies when he shot QE bazooka in 2020? Maybe they LITERALLY bought some puts this time as well :))).
Some EMs are doing better than the others - Brazil almost has real rates, as well as russia prior to war. China so far is fine (although they are facing other problems). But for some countries lack of global liquidity might be a real problem - take a look for country like Poland - their 10y went up from historical low sub 1% to 5 or 6%!! Or Colombia.
One (maybe stupid) thought: Is the interest rate hike the only option to tame the inflation? How about this MMT idea:
* Yield curve control just for government bonds
* At the same time introduce additional restrictions/regulations for new credit creation in the private sector
Isn't "insider trading" a la what Kaplan was doing ($1mn futures contracts even) the ideal training to be Fed chair? Your ability to profit is dictated by your ability to set market expectations which enable you to profit. Given Fed communications strategy, the ability to conduct insider trading is a job requirement indicative of job competence! LOL.
Since the Fed is behind curve they need to raise rates quickly and be much more aggressive. That will reduce ("kill") demand and bring inflation under control, just like lockdown "killed" oil demand in the spring of 2020. We know what happened next with the price of oil. Fed simply dosn't have time to reduce inflation by raising interest rates gradually. I was suprised how the Fed was dovish. If they don't raise rates at least 0,75% in the June inflation will soon exceed 10%. After 10% inflation is elusive. This will significantly increase market volatility. Higher rates means drop for cryptocurrencies. With such high inflation soft landing is an impossible mission.
Tl;dr: There's a structured note which levers the 2-10 spread which is requiring investors to hedge their exposure, effectively putting a floor on interest rate spreads. This is distorting rate hike expectations at the front-end, which might give out different signals.
I'm not exactly sure which security he is referring to, but if you find out would love to know!
Core CPI from the beginning of 2022, considering the average of 0.5% per month, is almost 2%, and to continue 2022 in the next 8 months and reach the 4% target, we need monthly inflation of 0.25%.
When you annualize monthly rates there is some compounding to consider, overall we need core inflation below 0.2% MoM approximately to make it to around 4% by year-end
Quickly follow up on this as I'm doing the math too - is it okay to use cpi MoM growth to gauge year-end PCE goal? I tried to look up pce actuals but could only find its YoY% on BEA.
Hi Alf. Could price stickiness in housing, where owners don't want to sell because of future price appreciation expectations, translate into higher shelter component CPI through increases in rent as owners attempt to cover increased carrying costs via increases in rents? Thanks!
Hi again Alf. If inflation remains higher than the target 2% rate, and central banks back off of further rate hikes, what effect would that have on mortgage rates? I would assume that banks could need to increase rates to generate a return due to the effect of inflation on returns from loans. Is this correct? I'm not sure of the mechanics and am hoping you can clarify this for me. Thanks! On another note, I think you would make a great guest on George Nobel's podcast :)
How does the China situation affect all of this? IMHO, the PRC economy seems to be downshifting significantly with no end in sight, which should affect oil consumption (they’re shifting to more coal) and housing/shelter (since they’ve still been U.S. housing, as we see here in California). Also, whenever they work through the Shanghai harbor pileup, we’ll have a lot of goods piling into the U.S., shifting from WIP to goods that need to be sold. All of these seem to be downward pressures on inflation. Is Mr. Market too much of a nervous flyer?
You are pointing towards interesting points. China is hugely contributing to the stagflation story via lower global demand and tightening up the supply chain massively - if things turn, those effects will be somehow reversed too.
Great piece per usual. You wonder if bond markets and/or the Fed are pricing in a mild recession bringing down inflation so the Fed won't have to on their own. Also curious if demand could dissipate faster than most expect - it seems every part of this cycle has happened so quickly and violently. Also hoping for the above to a degree because i've been hesitant to add inflation protection now at such high prices.
Even if demand comes down though there is no guarantee this will bring down inflation - what about supply bottlenecks and the sticky components of the inflation basket?
Right - in theory slowing demand should ease inflation pressure, but theory loses when practice and theory collide.
On your "What if" theme from an allocator lens, what if inflation subsides faster than expected and you decide to allocate to inf-protectors now? Or what if elevated inflation persists for a decade and you decide NOT to allocate now? It's hard to handicap which is the larger risk to my clients' long-term returns. Say inflation remains high for another 12 months, or somewhere in the middle of the two scenarios above - does NOT allocating still produce worse real returns looking back in 2040? 2 yrs elevated inflation still quite temporary in a 30-year horizon. Just thinking out loud in a public forum....
Good points.....can't argue with your analysis. In the coming months, it will begin to bite. Half point increases in June and July. Fed Balance Sheet run off starting and increasing in September.
Awesome read Alf. You touched a bit on real estate and seem to expect prices to come down a bit. As a young person who wants to buy something hopefully in the next 5 years... Any idea when it might be the most opportune time to buy? Not looking for a pinpoint answer obviously - just a general idea of what might be a good window to look more aggressively. Prices right now are insane 😑
Hey Chase! I expect real estate prices to slow down a bit, but if that's due to mortgage rates being much higher it won't lower your monthly installment costs anyway...
Think inflation will definitely be stickier for a few reasons. Some outside Fed control.
1) Oil/NG pass through.
Seeing end of first round now as oil stabilizes around $100/bbl with meaningful gyrations. BUT NG still moving upward as US converges towards Europe and Asian levels. Energy prices cascade through to goods prices over time as manufacturers usually cannot capture cost increases 1:1 and recoup losses/margin compression over month to years. NG prices will be especially pernicious as it feeds through into fertilizer then food, chemicals, and a host of other goods.
2) Russia/Ukraine offline.
Beyong oil/NG impact, this will have major repercussions for wheat, corn, seed oils and fertilizer supplies. Have only begun to see impact on those in Africa, Mideast, Southeast Asia who rely on supply from R/U. Food calories will see inflation in coming years. Fed can do nothing about this.
3) Supply line shortages from China.
Big wildcard as they continue to address Covid. Hear wild stories from friends in electronics industries about lockdowns and people living in their Chinese plants. People essentially isolating to keep production going. One case leads to outbreak and shutdown of production lines. Employees won't leave plant as fear of contracting virus, and not being allowed to return to job.
4) Rent/OER rent increases are serially correlated and can take years for price appreciation to flow through.
My mortgage has 9 years left at 2.5% interest. My taxes go up, but my ownership cost fixed for years. Rising mortgages do essentially increase cost for new home purchasers barring a (large) offsetting price decline in the house purchase price. Rents can lag for a while - In markets where HPA has been extreme, landlords may not be able to pass through 1:1 contemporaneously without losing tenants leading to lower but persistent YoY rent increases.
5) Fed may have less impact further out the YC than anticipated.
Long US rates tied to European and Japanese rates. Bund rates following US rates up but to a diminished degree. JGB's staying stubbornly low, but crashing the Yen. Borrowing is a GLOBAL market. Look back on the degree of curve inversion Volker needed to bring down inflation in the early 80's. Don't think that the Fed has the stones to go there.
Insightful comment, wow!
I do believe if you are right though the Fed won't have much of a choice - losing credibility for a Central Bank is even worse than a serious reversal in the wealth effect.
Hi Alf. Great article. I have re-read it a couple times this week because I think it is the core predictor of this market and our situation. It does boil down to credibility.
In fact the "sticky so far" has destroyed "transitory" completely of course, which damaged credibility. Actually 3 credibilities, 1) their mischaracterization of inflation expectations 2) the required U-turn in actions that were severely delayed, and now 3) not guiding sufficiently on how hard (hard-ish)a landing is to come.
So then they will reverse the reversal at say 5% inflation (not the stated 2%) for the sake of unemployment or a recession? Just abandon inflation targets altogether? That would be credibility annihilation.
The above comment about not having the "stones" proves they have lost a lot of credibility already.
What will coming fed policy effects be on housing market?
As always Alf great post, you should definitely publish more often!
I recall that just half year ago many market commentators were wondering what is the actual 'fed put strike' number after which they would withdraw their hawkish tone. Well 20% lower on sp500 it is still not there :)
Maybe this time they will use unemployment rate to adjust their policies back to QE (is it even possible with current inflationary/staglationary environment?
I wonder who will get caught in 2022 "lehmann moment". Will it be some sp500 company, some leveraged hedge fund or maybe even some country from EM bracket?
This time the Fed BOUGHT puts if you ask me :) they're happy to see some reverse wealth effect via tighter financial conditions.
Some EM places are quite at risk - especially the ones exposed to global trades, highly leveraged in USD etc (see Turkey)
Anyone remembers insider trading activities done by Powell buddies when he shot QE bazooka in 2020? Maybe they LITERALLY bought some puts this time as well :))).
Some EMs are doing better than the others - Brazil almost has real rates, as well as russia prior to war. China so far is fine (although they are facing other problems). But for some countries lack of global liquidity might be a real problem - take a look for country like Poland - their 10y went up from historical low sub 1% to 5 or 6%!! Or Colombia.
One (maybe stupid) thought: Is the interest rate hike the only option to tame the inflation? How about this MMT idea:
* Yield curve control just for government bonds
* At the same time introduce additional restrictions/regulations for new credit creation in the private sector
Isn't "insider trading" a la what Kaplan was doing ($1mn futures contracts even) the ideal training to be Fed chair? Your ability to profit is dictated by your ability to set market expectations which enable you to profit. Given Fed communications strategy, the ability to conduct insider trading is a job requirement indicative of job competence! LOL.
Since the Fed is behind curve they need to raise rates quickly and be much more aggressive. That will reduce ("kill") demand and bring inflation under control, just like lockdown "killed" oil demand in the spring of 2020. We know what happened next with the price of oil. Fed simply dosn't have time to reduce inflation by raising interest rates gradually. I was suprised how the Fed was dovish. If they don't raise rates at least 0,75% in the June inflation will soon exceed 10%. After 10% inflation is elusive. This will significantly increase market volatility. Higher rates means drop for cryptocurrencies. With such high inflation soft landing is an impossible mission.
Great post Alf. Thank you.
My pleasure, Gianni!
Great read as always, Alf! With regards to the inflation expectations curve, Michael Green of Simplify Asset Management recently gave a podcast where he mentioned something to this effect: https://open.spotify.com/episode/57dQDrjiKMAO6RBDFG1ChC?si=nkcn0SM2RjurNGX3qdTaHQ&t=1049 (timestamp 17:29)
Tl;dr: There's a structured note which levers the 2-10 spread which is requiring investors to hedge their exposure, effectively putting a floor on interest rate spreads. This is distorting rate hike expectations at the front-end, which might give out different signals.
I'm not exactly sure which security he is referring to, but if you find out would love to know!
I'll ask Mike :)
Great reading, as always. Shared it on Twitter.
Very kind, thank you!
Excellent take thanks Alf. (not sure of you know but there is a small repeated glitch on the audio feed?)
Ah, didn't know that!
Seems the Fed will follow inflation higher, talking tough all the way up, but letting the bond market lead.
HI Alf
Core CPI from the beginning of 2022, considering the average of 0.5% per month, is almost 2%, and to continue 2022 in the next 8 months and reach the 4% target, we need monthly inflation of 0.25%.
Is it right or am I wrong?
When you annualize monthly rates there is some compounding to consider, overall we need core inflation below 0.2% MoM approximately to make it to around 4% by year-end
(1.005)^4*(1.0025)^8 = 1.0407 ~ 4.1% IMHO Ali's calculation is right!
this is helpful, thank you.
Quickly follow up on this as I'm doing the math too - is it okay to use cpi MoM growth to gauge year-end PCE goal? I tried to look up pce actuals but could only find its YoY% on BEA.
Thanks Alf
My pleasure, Joe!
Hi Alf. Could price stickiness in housing, where owners don't want to sell because of future price appreciation expectations, translate into higher shelter component CPI through increases in rent as owners attempt to cover increased carrying costs via increases in rents? Thanks!
Yep, it could!
On the other hand though if real wages keep shrinking, not many people will be able to afford such higher rents.
Hi again Alf. If inflation remains higher than the target 2% rate, and central banks back off of further rate hikes, what effect would that have on mortgage rates? I would assume that banks could need to increase rates to generate a return due to the effect of inflation on returns from loans. Is this correct? I'm not sure of the mechanics and am hoping you can clarify this for me. Thanks! On another note, I think you would make a great guest on George Nobel's podcast :)
Well, if that's the case than CBs would have to react in a non-linear way as described. That would mechanically push mortgage rates higher too.
Thanks Alf! Really enjoying your macro trading floor podcast
So humble Alfonso, for you to take the time and effort to explain this to beginners like me. And share these, this is good noble work
It's my pleasure!
Superb read as usual Alf. Thanks!
Very kind!
How does the China situation affect all of this? IMHO, the PRC economy seems to be downshifting significantly with no end in sight, which should affect oil consumption (they’re shifting to more coal) and housing/shelter (since they’ve still been U.S. housing, as we see here in California). Also, whenever they work through the Shanghai harbor pileup, we’ll have a lot of goods piling into the U.S., shifting from WIP to goods that need to be sold. All of these seem to be downward pressures on inflation. Is Mr. Market too much of a nervous flyer?
You are pointing towards interesting points. China is hugely contributing to the stagflation story via lower global demand and tightening up the supply chain massively - if things turn, those effects will be somehow reversed too.
Great piece per usual. You wonder if bond markets and/or the Fed are pricing in a mild recession bringing down inflation so the Fed won't have to on their own. Also curious if demand could dissipate faster than most expect - it seems every part of this cycle has happened so quickly and violently. Also hoping for the above to a degree because i've been hesitant to add inflation protection now at such high prices.
Yep, it's the same questions I'm asking myself.
Even if demand comes down though there is no guarantee this will bring down inflation - what about supply bottlenecks and the sticky components of the inflation basket?
Right - in theory slowing demand should ease inflation pressure, but theory loses when practice and theory collide.
On your "What if" theme from an allocator lens, what if inflation subsides faster than expected and you decide to allocate to inf-protectors now? Or what if elevated inflation persists for a decade and you decide NOT to allocate now? It's hard to handicap which is the larger risk to my clients' long-term returns. Say inflation remains high for another 12 months, or somewhere in the middle of the two scenarios above - does NOT allocating still produce worse real returns looking back in 2040? 2 yrs elevated inflation still quite temporary in a 30-year horizon. Just thinking out loud in a public forum....
Good points.....can't argue with your analysis. In the coming months, it will begin to bite. Half point increases in June and July. Fed Balance Sheet run off starting and increasing in September.
They're going to tight the screws, shortly.....
Yep...
Awesome read Alf. You touched a bit on real estate and seem to expect prices to come down a bit. As a young person who wants to buy something hopefully in the next 5 years... Any idea when it might be the most opportune time to buy? Not looking for a pinpoint answer obviously - just a general idea of what might be a good window to look more aggressively. Prices right now are insane 😑
Hey Chase! I expect real estate prices to slow down a bit, but if that's due to mortgage rates being much higher it won't lower your monthly installment costs anyway...
Yeah makes sense. Thanks