Inflation is catching its breath. Should we worry?

It's That Inflating Feeling Again

The moment is almost here. US Consumer Price Index data will be available within a few hours of your receiving this. And after three consecutive downside surprises to end last year, traders will certainly be extracting every piece of data they can for clues on how the Federal Reserve may proceed with its rate-hiking campaign. 

All eyes are on the print, which is projected to run slightly hotter, rising 0.5% in January for the highest rise in three months. That's largely bolstered by a renewed upward shift in gasoline prices. The core price gauge, which excludes food and energy, is seen advancing 0.4% for a second month. If the numbers come in like this, then disinflation will not have made any great progress, but there would be no great worry that inflationary momentum was picking up again. After the surprisingly strong employment data for January, that would come as a relief:

At JPMorgan Chase & Co., a team has gamed the way the figures on the yearly change in the CPI could be received by the market. Bloomberg colleague Lu Wang reported the scenarios the firm has for various outcomes and how these would impact the S&P 500. Data close to estimates would be treated as confirming a continued cooling in inflation, which would imply falls for bond yields and the dollar, while tech shares would lead an advance for US stocks. But any equity gains are likely to fade, they warned, "once investors shift attention to a relatively slower pace of disinflation than the previous two months, where each CPI print saw a decrease of 60 basis points." The firm is betting on a print for year-on-year inflation that comes between 6.0% to 6.3% (which is bang in line with the consensus Bloomberg survey estimate of 6.2%):

Market moves over the last few weeks suggest a hurry to get away from bets that inflation will come down fast, especially since the jobs data. Two-year Treasury yields rose to a high for 2023 in the wake of the employment report, climbing 23 basis points last week as warnings from Fed officials that further interest-rate hikes suddenly seemed more believable. Traders are now reevaluating how high they will rise this year, fueling bets for the Fed to peak at 5.2% in July, up from less than 5% a month ago. 

More importantly, confidence in swift easing later this year has evaporated. Looking at the Bloomberg WIRP (World Interest Rate Probabilities) function, which derives probabilities from the fed funds futures market, the implicit rate for the December Federal Open Market Committee meeting has never been higher since the start of the contract. Nearly at 5%, it suggests that there will be no rate cuts this year: 

The bond market's expectations for inflation have also jolted higher since the unemployment numbers. The two-year US breakeven rates on Treasury inflation-protected securities — or the difference between those yields and the ones on typical Treasuries — is now significantly above the level at which it started in December. The five-year gauge also increased. On this measure, two months' belief in disinflation has been swiftly reversed:

Understandably as estimates reset so swiftly, market chatter is now leaning toward an upside surprise. If the report does indeed turn out "fierier" than forecast, Greg Bassuk, chief executive officer at AXS Investments, said this could shake up the stock market, which according to many has risen too far, too fast on hopes of a more dovish Fed:

A red-hot January CPI print against the backdrop of mediocre corporate earnings would jumpstart volatility and weigh on the equity market, with investors scrambling to risk-off positioning on fears of ongoing rate hikes, recessionary concerns, and the lack of visibility on the trajectory of the economy and markets in the months ahead.   

Such talk has taken hold since the employment data. Despite this, Alan Ruskin, macro strategist at Deutsche Bank Research, says the "collective wisdom" of the market economists in Wall Street sees risks heavily skewed to the downside of the 0.4% core median. Before the nonfarm payroll report in January, markets wanted to go with thoughts of softer growth and inflation trends, he said, but now a hot inflation number, while unwelcome, would at least make it easier to explain what's going on with the economy:

Since NFP, it is almost easier to have CPI not surprise to the downside, in so much as the most important growth and inflation signals would better align rather than contradict, and affirm the more recent hawkish bent.

It's also as well to look out for "noise." The headline print is expected to accelerate thanks to gasoline prices, said Stephen Stanley, chief US economist at Santander US Capital Markets LLC. Fuel costs fell sharply in November and December but bottomed out late in the month and rose substantially in January. Headline inflation, he added, may have risen by 0.5%:

Further progress in the deceleration of the year-over-year core CPI figure may be limited over the next few months, though the disinflation will pick up some momentum when big core rises in May and June of last year fall out of the 12-month window.

For Joe Quinlan, head of CIO Market Strategy for Merrill and Bank of America Private Bank, if Tuesday's data support the view that inflation will moderate more slowly than hoped, there will be volatility in resetting asset prices: "We're not looking for the Fed to raise rates 50, but 25 is still out there for sure. And then the market has to come to the terms with pushing out any rate cut." 

One way to make the Fed's life easier, and spare everyone from a protracted dose of higher inflation, would be to raise the inflation target. But Fed speakers make clear that they're sticking with 2% annually. To get there, warns Don Rissmiller of Strategas Securities, the hard part will be wages. With labor demand currently greater than supply, the Fed "seems unwilling to take a risk" to wait and see if wage growth can stabilize or slow with low unemployment.

Wage-stickiness feeds into another critical concern for the Fed, which is that the inflation expectations in the population may become "un-anchored." In such conditions, wage demands will be higher, and high inflation forecasts can become self-fulfilling prophesies. On this terrain , there is good news. Monday saw the release of the New York Fed's January 2023 "Survey of Consumer Expectations" and results show that there is actually little change in inflation expectations at the short-, medium-, and long-term horizons. Over three years, forecasts now appear to be comfortably back within the target range after deviating far above it. 

Re-anchored

Consumers' medium-term inflation expectations look to be under control

Respondents said that they had seen heightened price changes for food and energy, while expectations for medical costs and rent remained stable. The expected increase in home prices, however, slowed last month to hit its second-lowest reading since May 2020 — which could be interpreted as a sign that higher mortgage rates are doing the intended job of deterring people from inflationary speculation. 

What does this tell us? Even if the market briefly convinced itself that inflation was beaten, and then changed its mind in the course of a month, the view of people at large has been more consistent, and it's one the Fed can live with. Now to see if the calm survives the CPI data. 

So, Why Is the Stock Market Up?

The new year rally remains intact. The reversal in forecasts for rates has had little or no effect on stocks, with the S&P 500 up 7.76% for 2023, and many other markets around the world doing even better. How so?

Not Earnings

It certainly isn't because of corporate earnings, which haven't been good. Usually, Wall Street estimates for a quarter tend to increase once the quarter is over — it's all part of the physics of companies talking down their prospects to give themselves a lower bar to clear. The fourth quarter of 2022 is proving to be a very significant exception. The following chart is from Jonathan Golub, US equity strategist at Credit Suisse AG:

This is very far out of the norm. Steady disappointments during earning season, on this scale, have in recent decades only happened when the economy is entering a recession, or a financial crisis, or both. This elaborate Credit Suisse chart shows how unusual this is:

All of this is consistent with the onset of an earnings recession. Savita Subramanian, quantitative strategist at Bank of America Corp., summarizes the process as follows:

The earnings downturn so far has been driven by margin compression and decelerating but still positive sales growth. This is typical of the early stages of an earnings recession: sales slow faster than costs, resulting in the initial earnings decline. The next leg is driven by sales decelerating further which we think is likely in a soft or hard landing. Here, companies typically can't cut costs fast enough, resulting in a more dramatic deterioration in earnings. 

If consumers stay resilient, then, a deep earnings recession is still avoidable. But there is no reason for greater optimism stemming from the earnings announcements themselves. They point to a downturn.

Tail Risk

There is, however, a perverse way in which the rise in expected interest rates could be positive. Think of the concept of "expected value," in which each outcome is multiplied by its probability, and then all are summed. For example, the expected value of a coin flip with 1 on one side and 2 on the other is 1.5 — even though there is no chance of such an outcome. While the sum of all expectations expressed by the market comes out to rates of about 5% at the end of the year, up from 4.5% a few weeks ago, that doesn't necessarily mean anyone actually expects the fed funds rate to be at these exact levels. Rather, there is a likelihood that the economy muddles along with no need for cuts, and a possibility that it falls fast, bringing rates down with it.  

The way these mathematics work out is demonstrated in this nice example by David Zervos of Jefferies Macro, who was writing two weeks ago when rate predictions were lower:

Suppose the market probability distribution for rates in December has 90% of its mass centered normally around 4.90% and the other 10% of its mass centered normally around 1%. This is what we would call a bimodal distribution. In that case the expected value for December would be 0.9 x 4.90% + 0.1 x 1.00% = 4.54%. In this case, would it be fair to say that the market has 36bps of rate cuts "priced in" by year end? Absolutely not. There is only a tiny probability of a 4.54% rate under this structure. With this distribution, it would be accurate to say that the market most likely sees rates in December unchanged from their peak summer level of 4.90%, but there is a "fat tail" to extremely low/ZIRP type rates. We would argue that this type of bimodal distribution represents a far more reasonable description of the current Fed reaction function than anything like a standard normal distribution.

His conclusion was that we should not "buy into this gobbledygook about a couple of rate cuts being priced into December" as the Fed was still "ONLY around to help in the very unlikely event of a crash landing." Very strong numbers on employment and services make that crash landing look less likely — and that should be good for stocks, even through it also means that rates rise in the here and now. 

Liquidity

Finally, the single biggest reason for the rally is liquidity. There's more money about, it has to go somewhere, and so it's predictable that a lot of it flows into stocks. There are many sources from which money appears to be moving more freely, but by far the most important is the People's Bank of China (PBOC). It's unlikely that China's central bankers are thinking too much about the US stock market when they make their decisions, but they've been very helpful. This is from Mike Howell of CrossBorder Capital, who monitors liquidity:

Late last year, we predicted that the end of the Covid lockdowns would probably coincide with an easier monetary stance by the PBOC. However, even our optimism has been overtaken by the whopping liquidity injections ploughed into Chinese money markets since late November 2022 through December; the PBOC injected RMB 1.56 trillion, adding another RMB 1.45 trillion in January, and so far through February the rolling 28-day total is a sky high RMB 1.93 trillion Admittedly, this breakneck pace of impetus will fall off, but in two months the Chinese have added 3-3 ½ times the liquidity they put in, in total, during the prior two years!

While the risk of a crash landing stays low, and money keeps flowing from China, the US stock market can withstand rising rates and falling earnings. Now to see how it deals with the January consumer price inflation figures.

Correction

Thanks to a typographical error, Points of Return last week said that the S&P Case-Shiller 10-city house price index was about 20% below its peak. It was in fact 5.2% down from the peak, as was clearly indicated by the accompanying chart we published at the time. 

Survival Tips

I have a late literary recommendation. A few years ago, the journalist Tim Marshall published a book titled variously Prisoners of Geography and The Power of Geography, to much acclaim. I've just read it and I can see why. It's a brief and unpretentious but complete read, explaining why the strategic and political priorities of countries around the world are dictated by their geography. It's fascinating and very useful as we are all forced to grasp how important geopolitics is once more. The edition I read was published in 2016, and it has aged startlingly well. This is how the book begins:

Vladimir Putin says he is a religious man, a great supporter of the Russian Orthodox Church. If so, he may well go to bed each night, say his prayers and ask God: "Why didn't you put some mountains in Ukraine?"

Reader read on. 

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.