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What You Missed: Both long and short-term interest rates rose, and equities traded sharply lower on the week. Market confidence was undermined by intensifying inflationary pressures and the expectation of expanded interest rate hikes to combat it. The yield on the US 10-year Treasury note continued to rise, reaching 3.15% from 2.95% a week ago, joined by similar rises in the two and five-year Treasuries and Term SOFR. Elsewhere, the price of a barrel of West Texas Intermediate crude oil rose $3.25 to $120.50, as the US Dollar and Gold both strengthened. Treasury yield volatility, a key but unseen driver of the cost of rate caps and other option-based interest rate hedges, rose to a three-week high.
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Inflation set a new peak – will it get worse before it gets better? The Consumer Price Index (CPI), one of the Fed’s favorite gauges of inflation, rose 8.6% year over year in May, a new four-decade high, while core prices, which exclude food and energy, more indicative of the underlying inflation trend, rose 6%. Month over month, a more realistic inflation measure, climbed 1% from April, 0.6% after stripping out food and energy. Inflationary pressures are broadening. Energy prices rose nearly 4% month over month while airfares vaulted a whopping 12.6%. Housing costs, which make up more than 40% of CPI, rose 0.8% from the month before.
Investors, who expected CPI to signal that inflation had peaked, were surprised by the jump, prompting traders to price in 0.50% rate hikes at the Fed’s June, July, and September meetings. The moves imply that the federal funds rate – the rate the Fed moves around when it hikes or cuts – will peak at 3.5%, a new high. Short-term bonds, which are more susceptible to Fed rate hikes, led the Treasury selloff, with the 5-year yield jumping 19 basis points to 3.25%, following the 2-year higher. Thirty-year yields are now at 3.19 percent, up 3 basis points.
Our take: The likelihood of a worsening inflation picture is high. We suspect that the next set of CPI data for June, released in early July, will show a 1% monthly gain, on the back of the national average gasoline price approaching $5 per gallon in the early weeks of June, combined with renewed inflation pressures emanating from China’s reopening from COVID lockdowns and Europe’s looming embargo of Russian energy. Even though America’s economy is already slowing, the dynamic will keep the Fed firmly on the path of 0.50% rate hikes at its June and July meetings, with a 0.50% hike in September looking more and more likely.
Looking further out, even if energy prices stabilize and then begin to decline before the end of the year, as oil-futures curves predict, headline CPI will average more than 7% in Q4. That will keep pressure on the Fed through the end of the year, owing to inflation’s stubbornly slow decline. But does it mean we’ll see 0.50% rate hikes at every Fed meeting through the end of the year as some project? We don’t think so. 0.50% rate hikes this week, in July and in September will emanate through markets and the economy, slowing things down enough to give the Fed room to then pause and contemplate its next moves.
In the meantime, a stealth driver of inflation to keep an eye on is rents, which comprise 30% of the CPI. Changes in rents impact CPI with a lag, which implies that rising housing-cost measures may delay a peak in CPI until early 2023 or even later. The monthly change in rents of primary residence (RPR) and the owners ‘equivalent rent component are pointing to higher run rates than during the mid-2000s housing boom. These will keep inflation higher for longer, adding roughly 2 percentage points to CPI well into 2023.
Consumer sentiment dove to a fresh low – are well all doomed? The preliminary reading of the University of Michigan’s consumer sentiment index for June declined to 50.2, a historic low, from 58.4 in May. The mood of US consumers, who drive roughly 70% of all economic activity, is now at an all-time low, diving past levels hit during the Global Financial Crisis of 2008 and the Paul Volcker– inspired inflation shock of the 1980’s. The data added to the doom and gloom mood shown by other gauges – including the New York Fed’s gauge of inflation expectations – that have risen significantly. The fact that consumers see conditions as so poor partly reflects the view that worsening sentiment could soon translate to significantly weaker spending – a key ingredient to maintaining any positive US economic momentum.
Our take: Even though pent-up demand and healthy household balance sheets will keep us all spending in months ahead, the plunge in consumer sentiment shows risks of a significant slowdown are intensifying, implying that recession lies in wait in mid-2023. The double-whammy of high and rising inflation and tanking consumer sentiment will embolden the Fed to keep on trucking toward 0.50% rate hikes through July.
Upturn in jobless claims flashes another warning sign. Weekly initial jobless claims have been trending higher since bottoming out at 166,000 in mid-March, with the most recent print coming in at 229,000, well above the pre-pandemic 2019 average of 218,000. Economists look at the jobless claims data as an early warning sign of a recession since, historically, if the number of claims reaches a low point then rises, recessions usually follow within nine to 18 months. Something to keep an eye on.
The ECB left the door open to a half-point rate hike in September – should you care? Yes you should, as any inclination on the part of the ECB to hike only adds momentum to hikes by our beloved Fed. While the European Central Bank (ECB) didn’t hike rates at its meeting on last Thursday, it announced that it plans to raise rates by 0.25% in July, with the possibility of a 0.50% hike in September if inflation “persists or worsens”. The ECB added that moderate but persistent hikes will be reasonable after September. Inflation in Europe is expected to average 6.8% in 2022, while core inflation is expected to average 3.3%. Adding to the momentum, a number of other central banks hiked rates last week amid surging global inflation, including the Reserve Bank of India, which raised rates 0.50% to 4.9%; the Reserve Bank of Australia, which raised them by 0.50% to 0.85%; and the Central Bank of Chile, which hiked by 1.5% to 5.5%.
The U.S. interest rate market has never been more complex than now. Derivative Logic’s decades of experience will help you and your business navigate the choppy waters ahead. Let’s discuss your unique situation and keep you heading in the right direction. Call us today at (415) 510-2100.
What to Watch This Week: With storm clouds gathering over the US economy, it’s all about Wednesday’s Fed policy meeting, the widely expected 0.50% rate hike, and the nuances of just how Fed Chair Jerome Powell will dial up the hawkishness to combat high and rising inflation.
The Fed meeting comes amid clear evidence that the economy is cooling: The S&P 500 is down about 18% this year, housing demand is tanking (NAHB, Wed.; housing starts, Thurs. ), consumer sentiment is at recessionary levels, and layoffs or hiring freezes are beginning to appear in a few sectors (jobless claims, Thurs.). Cooling demand (retail sales, business inventories, Wed.) has improved the supply-demand balance for some consumer-discretionary items, keeping price increases in those sectors in check. In total, the situation has prompted some – us included – to believe the Fed will pause rate hikes later this year as a result, to avoid driving the economy off a cliff, especially given growing fears of recession.
The risk to that belief? That inflation won’t slow fast enough for the Fed to justify a pause in its rate hiking plans late this year. For certain, inflation will remain stubbornly high through all of 2022, and it’s just a question of what Fed Chair Powell really meant when he said the Fed needs to see ” clear and convincing” evidence that inflation is slowing. That evidence thus far is mixed: Excluding food and energy costs, all inflation gauges would suggest that inflation’s peak is already in the rearview mirror. Including food and energy costs, inflation will set new highs in coming months, while the Fed’s preferred gauge – the PCE deflator – may not. Fed Chair Powell has stated that he doesn’t care about these nuances and will likely assert that inflation is still on the rise, and that the Fed will continue to hike by 0.50% at every meeting as long as that is the case.
Markets will also focus on this week’s release of the Fed’s updated dot plot for clues on whether the Fed will hike its Fed Funds rate to 2.5% this year and above 3% in 2023. Even though the dot plot has proven to be a horrible predictor of where Fed Funds is headed, markets focus on it intently regardless.
Big Picture: All the recent data confirms that by letting inflation run hot, the Fed is hurting consumers, the backbone of the economy. And by leaving us all in the dark about how many rate hikes we’ll see is weighing heavily on economic growth prospects and sparking fears of recession. Why don’t they just hike 1.0% this week an get it over with?
The Fed is not new to the concept of front-loading rate hikes. Some in the markets – we’re one of them – believe inflation would be smothered and economic growth would recover sooner rather than later if the Fed delivered its desired multiple rate hikes in one foul swoop, say by hiking by 1% this week. So why don’t they do it? Transparency. The Fed doesn’t like to surprise markets and given last week’s equity sell off and jump in bond yields, which continue this morning, by hiking more aggressively than expected, they’d be doing just that.
In the short-term, expect higher rates and a stronger US Dollar until the Fed either signals a pause or goes past the breaking point and the economy tilts into a recession. There is some hope that the smoke will clear after this Wednesday’s Fed meeting, specifically what the Fed’s intentions are for September. Once markets find that direction, stand aside, as we’ll see big moves in rates one way or the other.
And what of all the talk of stagflation? Are the fears justified? With inflation at its highest level in 40 years, and growth slowing, many are concluding that America’s economy is doomed to experience another round of stagflation akin to the 1970s. They are mistaken.
Stagflation is caused by a toxic mix of three factors: high inflation, high inflation expectations, and stagnant economic activity. Stagflation is at the top of any central banker’s fear list because once it takes hold, inflation may remain high even if the economy isn’t overheated.
To get a sense of how likely the risk of stagflation is now, it’s best to look back to the last bout of stagflation, seen in the 1970’s. The stagflation seen then was a textbook example: PCE inflation reached north of 11% at the end of the decade, following two big oil shocks, unduly stimulative fiscal policy, and ineffectual monetary policy. Inflation was high and rising, even though the economy wasn’t overheated.
Today’s scenario is different. Yes, inflation is too high, the jobs market is dangerously overheated and needs to be cooled. The public is still optimistic that the Fed will ultimately gain control of the situation. By design, that will cause economic growth to slow and nudge unemployment higher. It’s evident in Treasury market pricing, gauges of the consumer’s state of mind, and professional forecasts. The fact that confidence has not been substantially harmed is likely attributable in part to the recent development of today’s inflation, as opposed to the 15 years of blunders that created the stage for then Fed Chair Paul Volcker.
The bottom line? It will be substantially less expensive to bring inflation under control – in terms of lost employment and output – as long as the Fed maintains public and market confidence. If the Fed loses its inflation anchor, the recession that will be needed to bring inflation under control will be much deeper. If the Fed can retain the public’s confidence, its job will be much easier. Until then, get to know Paul Volker, as you’ll hear his name referenced over and over again in the coming months.
In the meantime, for borrowers, flexibility in interest expense is critical. Who is helping you avoid the potholes that lie ahead?
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Source: Bloomberg Professional