Fed plans to raise rates as soon as March to cool inflation

[jaichind]

Reading the market commentary on the Italian-German debt spreads surge reinforces some of the ideas I put out there.  Before the inflationary surge and with expectations that Italy can continue to borrow at negative real interest rates the Italian debt spreads implied that Italy's debt as a % of GDP would fall from 155% today back down to a pre-COVID 19 level of 135% in a couple of decades as emergency spending are withdrawn.  Now with the inflationary surge which in theory should help Italy finance its debt has the market pricing in the fact that Italy will soon face positive real interest rates.  Given how much debt Italy has to refinance and roll over in the coming years the market now prices Italy's debt to GDP to fall a bit as COVID 19 spending is withdrawn then surge to 180% of GDP on the backs of crushing interest payments which in turn add to the debt.  The USA will go through a much smaller version of this but will encounter fiscal adjustment.

[jaichind]

Long-term Inflation swaps surged on news of a 75 bp increase (vs 100 bp).  The market was expecting a bigger increase as part of the path to defeat inflation.  This decision just means the path to reduce inflation will be greater and the recession to come will be a bit later but will be bigger.

[jaichind]

(Bloomberg) --Former Treasury Secretary Lawrence Summers called on the Federal Reserve to deliver a clear message saying it will need to impose “restrictive” monetary policy that drives up the US unemployment rate in order to quell inflation.
“My worst fear would be that the Fed will continue to be suggesting that it can have it all in terms of low inflation, low unemployment and a healthy economy,” Summers told Bloomberg Television’s “Wall Street Week” with David Westin.

[jaichind]

https://www.reuters.com/markets/us/two-fed-bank-boards-wanted-100-basis-point-discount-rate-rise-july-2022-08-23/

"Two Fed bank boards wanted 100-basis-point discount rate rise in July"

Good, let's get going, let's get it done.

[jaichind]

Look at treasury yields plus inflation swap numbers last couple of weeks it seems the bond market thinks the war on inflation has been half won despite a wishy-washy Fed.  Part of it is of course a recent bear market bounce which I am sure will revert to the mean soon. 

Reading bond market commentary it seems the reason for this view in the bond market is not some great confidence in Powell but more that EU-UK will take the hit for the USA.  The current inflation surge is of course driven by years of QE plus the blowback on Russian sanctions as part of the Russia-Ukraine war.  Bond market commentary seems to feel that the inflationary situation in EU-UK is hitting such a crescendo that an economic implosion not captured by current macroeconomic projections is certain to hit soon and push down overall aggregate demand in the world and drive down inflation in the USA. 

While this line of thinking has merit I think the same bond market has to take into account the risk of "lock-in" of inflationary expectations in the USA, especially with respect to consumer price and labor price pricing power much like what took place by the late 1970s.  Also, the PRC which had recent economic slowdowns due to its ill-advised COVD-19 lockdowns plus a real estate bubble bursting is certain to be expansionary in terms of fiscal and monetary policy.  I am not sure these factors are being taken into account by the bond and inflation swap markets despite the fact that their EU-UK Russian sanction blowback economic implosion theory seems more and more likely to come true.

[jaichind]

Powell Offers Succinct Warning of `Some Pain’ Ahead.  Market falls.  Again this is just facing reality. 

[jaichind]

Looking at the previous CPI report and expected CPI report coming up it seems that the situation is getting under control.  Stripping out energy and food the CPI MoM last month was 0.3% and is expected to be 0.3% in the next report.   This is compared to the ~0.6% non-food/energy CPI MoM last few months.  It seems the big inflation spike momentum earlier in the year is slowing down.  This is a moderate version of what happened in Russia where there was a massive price spike in Feb-April but then have actually moved into deflation with negative CPI MoM.  This slowdown is taking place even though the Fed Funds rate has only moved up somewhat.

I think the reason for this is high inflation expectations by the late 1970s took very prolonged high Fed Fund rates to wipe out whereas recent inflation expectations in the 1990s-2010s period have been and stayed low.  This is helping restrain inflation.   If so then perhaps the "team transition" of 2021 might have been right.  What took place was two large inflation hammer blows in 2021 and then 2022 but both then dissipated.  What "team transition" got wrong was the scale of the spike but they might have been right all alone. To be fair we will know more over the next few months are more CPI MoM data comes in.

[jaichind]

Looking at the previous CPI report and expected CPI report coming up it seems that the situation is getting under control.  Stripping out energy and food the CPI MoM last month was 0.3% and is expected to be 0.3% in the next report.   This is compared to the ~0.6% non-food/energy CPI MoM last few months.  It seems the big inflation spike momentum earlier in the year is slowing down.  This is a moderate version of what happened in Russia where there was a massive price spike in Feb-April but then have actually moved into deflation with negative CPI MoM.  This slowdown is taking place even though the Fed Funds rate has only moved up somewhat.

I think the reason for this is high inflation expectations by the late 1970s took very prolonged high Fed Fund rates to wipe out whereas recent inflation expectations in the 1990s-2010s period have been and stayed low.  This is helping restrain inflation.   If so then perhaps the "team transition" of 2021 might have been right.  What took place was two large inflation hammer blows in 2021 and then 2022 but both then dissipated.  What "team transition" got wrong was the scale of the spike but they might have been right all alone. To be fair we will know more over the next few months are more CPI MoM data comes in.

This all collaborates that we probably need to go back to historically normal interest rates (3-5%).

I am coming closer to that point of view.  I would need to see what the CPI MoM numbers look like.  Whereas before I was thinking we need to get to 5%-6% fed rate.  Now I think perhaps 4%-5% might be good enough if the underlying inflation exepectations momentum is what it is.

[jaichind]

One way or another the next Fed meeting the Fed fund rate is expected to go from 2.5 to 3.25.  My current guess now it will eventually hit 4-5 after that but after that most likely stop or even go back down.

Note that in the late 1970s and early 1980s the Fed Fund rate had to stay above inflation for several years before the CPI MoM momentum slowed down.  Such was the impact of the inflationary surge of the 1970s.  Still it is on the Fed to ensure that inflation head down to 2% or so and stay there so an inflation rate of above 4%-5% is not viewed as "normal"

[jaichind]

What would be the problem with more historically normal inflation(3-4%)?

There would be a problem for the Central Bank to not have price stability.  The Central Bank is competing against other stores of value (gold etc etc) so price stability would mean the value of a currency is stable and people would use it more than its competition.  So in theory Central Bank would want 0% inflation.  The 2% target in the USA came into place mostly due to fears of deflation and a liquidity trap.

[jaichind]

Latest CPI comes in at 8.3%, higher than expected.  Non-food/oil MoM came in at 0.6% which is fairly high.  Seems inflationary pressure is still there that the Fed will need to act against.

[jaichind]

Fed swaps now have it at near 100% chance that Sept fed hike will be at least 75 BP

[jaichind]

It seems what drove up the latest inflation number is rents.  If so that is a lagging indicator since many rent contracts most recently neglected might and most likely are reflecting the rise in the rental market that took place months ago.  In that sense, these are grounds to believe that this surge might subside the next data points.  Still just to make sure I still think it is best that the Fed push rates up to 4.5% and beyond.  It can always lower them later.

[jaichind]

What would be the problem with more historically normal inflation(3-4%)?

There would be a problem for the Central Bank to not have price stability.  The Central Bank is competing against other stores of value (gold etc etc) so price stability would mean the value of a currency is stable and people would use it more than its competition.  So in theory Central Bank would want 0% inflation.  The 2% target in the USA came into place mostly due to fears of deflation and a liquidity trap.

How did things work with 3% inflation?

Well, the higher that number is the more you are driving "forward" planned consumption since the purchasing power of the currency is falling.  Where the economy is in a liquidity trap where supply way outstrips demand this might have some good short-term effects without creating long-term problems.  If not you are just adding uncertainly in the system and lowering logical investments and risk taking.

[jaichind]

It seems what drove up the latest inflation number is rents.  If so that is a lagging indicator since many rent contracts most recently neglected might and most likely are reflecting the rise in the rental market that took place months ago.  In that sense, these are grounds to believe that this surge might subside the next data points.  Still just to make sure I still think it is best that the Fed push rates up to 4.5% and beyond.  It can always lower them later.

There's probably still a ways to go, unfortunately. I didn't realize how behind CPI was compared to other measures of rents.

Yes.  My point is that inflation might be running at over 8% but the average person might not be "experiencing" 8% anymore due to rent component catchup.  For most people, the rental market became crazy a year ago which they experience but is only now showing up in CPI numbers.

[jaichind]

That might mean that raising interest rates too high might be unnecessary.

Yes, it would add to the argument that the increase in Fed rates might not need to be as aggressive as what the topline numbers might suggest.

[jaichind]

Fed Fund swap trading indicates that the marker expects rates to peak sometime next year at 4.5%  If such expectations ends up than that expect equity markets to fall some more from here.

[jaichind]

Really comes down to non-food/energy MoM numbers.  If that falls to 0.2% or lower then the base effects would mean the YoY CPI numbers will fall and fall quickly throughout 2023.

[jaichind]

Fed raises rates 75 bp as expected.  Powell says that a recession might be necessary to bring inflation under control.

For the first time using my inflation-adjusted yield curve (discounting the yield curve with inflation swaps at each tenor) as the curve inverted (the convention curve has been inverted for a while) although only mildly.  It does seem that a recession next year is coming.   Given how mild my my inflation-adjusted yield curve is is it possible that it will be a mild recession.

[jaichind]

My calculated 30-year inflation-adjusted yield (which discounts the 30-year treasury yield by the 30-year inflation swap) reaches 1.22% which is the highest since 2011.   It was -0.6% in early 2022.  The pre-2008 era has this metric between 1.5%-2.0%.  I think we are getting very close to the end of the adjustment transition to the pre-2008 era as far as federal borrowing costs are concerned.

[jaichind]

My calculated 30-year inflation-adjusted yield (which discounts the 30-year treasury yield by the 30-year inflation swap) reaches 1.22% which is the highest since 2011.   It was -0.6% in early 2022.  The pre-2008 era has this metric between 1.5%-2.0%.  I think we are getting very close to the end of the adjustment transition to the pre-2008 era as far as federal borrowing costs are concerned.

So people are selling stock and even commodities/metals to lend the Government money because it’s willing to pay more?

Of course.  Because the USD is the reserve currency in the world and the USA government can always pay its debts if you can get plus 1% after inflation return on USA treasuries that is very attractive to many people.  As I head toward retirement I am already rotating into long-term fixed income and this turn of events is the best thing that can happen for me.

[jaichind]

The 30 inflation-adjusted treasury yields that I am computing surge to 1.4%.  This is getting very close to the 2004-2007 average of around 1.5%.  The real federal government borrowing costs are surging before our eyes.  If it goes to 1.5% and stays there then one can finally say that the USA has finally exited the abnormal post-2008 financial crisis era.  In 2008 I thought it would take 5-10 years to get out of the shadow of the crisis but it now seems that it took fully 14 years.

[jaichind]

For the first time using my inflation-adjusted yield curve (discounting the yield curve with inflation swaps at each tenor) as the curve inverted (the convention curve has been inverted for a while) although only mildly.

Out of curiosity (I studied valuation and work in banking), why do you do it that way? And is this alternate measure widely used? Have you tested its reliability in the past?

(Hope I'm not derailing the thread here)

This is totally made up by me and has no real backtesting behind it.  I came up with the idea of discounting the treasury yields by the inflation swap of the same tenure back in the 2010s mostly as a way to measure financial repression.   My observation was that in 2012 there was massive financial repression which was fairly accommodative toward the Obama 2012 re-election campaign.  Of course, this was able to measure the massive financial repression in the 2020-2021 period as well. 

The idea of creating a yield curve out of my numbers came more from criticism I read in various reports half a year ago that using the yield curve to predict recessions had the problem that it did not take into account the large differences between short-term and long-term inflation.  These reports did not come up with solutions to the problem.  I merely used my numbers as a way to adjust for this.  Now that short-term and long-term inflation numbers are beginning to converge makes my adjustments are less useful and relevant going forward anyway.

[jaichind]

30-year treasury yield discounted by 30-year inflation swaps surges past 1.5%.  We are officially exiting from the post-2008 financial repression world.  It feels so good to be free.

[jaichind]

US Dollar index USDX is the highest level since 2001.

If you look at JP Morgan's broad-based currency strength adjusted for CPI differentials between different economies the USD is at the highest since the 1985 Plaza accords.  Looking at the JPM CPI differentials adjusted currency index shows that CNY and INR are still fairly strong and it is really EUR, GBP, and JPY that are way down at historical lows that are driving the USD relative strength.

At some stage ECB, CBE, and the BOJ will have to accept reality and raise rates and these trends will readjust itself.