Markets now recognize disinflation approach

The CPI came in at +0.4% M/M for October, much better than the consensus estimate of +0.6%, and the Y/Y number, a Fed favorite, fell to 7.7 % versus 8.2%. The financial markets rejoiced. Tech-heavy indices, which had been hardest hit in recent market selloffs, rose the most. The Nasdaq rose 7.9% on Thursday; the S&P 500 rose 5.5% and the less tech-heavy DJIA lagged but still rose 3.7%. The “core” rate (excluding food and energy) only increased by 0.3%.

Although this CPI and the trends it contains were unexpected for the markets, it did not surprise us, as we have always believed that the markets have been too bearish on the future of inflation.

Excluding housing (+0.8%), energy (+1.8%) and food (+0.6%) (none of which are likely to repeat such readings in the near term), the rest of the index actually fell -0.1%. There have been price cuts in:

• Medical care
• Financial services
• Car rental
• Airlines companies
• Delivery services (which says a lot about the state of the consumer)
• Used vehicles
• Clothes
• Furniture
• Appliances

· In past blogs, we’ve talked about the outdated way the Commerce Department calculates rent. The rise in rents in this CPI report was the highest since August 1990. We know that in the private market rents have fallen and we know these will show up in the CPI releases this year. coming soon, putting downward pressure on the index.

· Energy and food prices are already high; if they just stopped rising, the CPI Y/Y, which apparently leads the Fed, would fall to 1% by June. The chart shows where CPI Y/Y would lie with monthly growth rates of 0.0%, 0.1%, 0.2% and 0.3%.

· We may have a few months of negative CPI growth. This will happen if food, energy and rent prices simply stabilize. Let’s be careful and use the 0.2% column. In June, the backward looking CPI Y/Y measure used by the media would be 2.6% and it is likely that we will be in a deep recession. Until then, it seems pretty obvious that the Fed will have to start cutting interest rates.

· As of this writing, it looks like the Fed will hike rates by 50 basis points (bps) at its December meeting. However, there is still one employment report and another CPI report before this meeting. A weak jobs report and another strong November CPI might even convince them to rise only 25 basis points; and maybe that will be it for this crunch cycle.

It looks like fixed income markets are starting to price this in, as on Thursday the yield on 2-year T-Notes fell -30 basis points (bps) (i.e. -0 .3% points), 5-Yr fell -35 bps, 10-Yr fell -33 bps and 30-Yr fell -26 bps. (I hope everyone bought Treasuries on Wednesday!)

Financial stability

One of the characteristics of tightening cycles is that it exposes the debt overhang that often accumulates when, prior to tightening, central banks have been accommodative for too long. It is well recognized that in this cycle, the Fed and the other major central banks have remained far too accommodative (interest rates close to 0%) for too long. To top it off, this particular tightening cycle was the fastest since the Volcker era (early 1980s) (see chart above). During these periods, various instabilities appear. Classic examples are the bankruptcies of Long-Term Capital Management (1998) and Lehmann Brothers (2008). There have been others: Orange County (1994) and Penn Central (1970; almost eliminating Goldman Sachs) come to mind. Almost all of these events happened when interest rates rose, exposing those who got into over-indebtedness.

In today’s world we have recently seen the Bank of England come to the rescue of UK pension schemes which have been overleveraged due to low yields for so many years, and we have seen other central banks use a significant part of their reserves to support their currencies (Bank of England, Bank of Japan, People’s Bank of China, European Central Bank, etc.).

Last week, the cryptocurrency market crashed as major crypto platform, FTX, suffered the equivalent of a bank run and filed for bankruptcy. Its CEO and founder, Sam Bankman-Fried, saw his $23 billion net worth disappear overnight. We have also seen the Bank of Korea intervene on the exchange (FX
Effects
) markets to protect the value of the Korean won. It added $36 billion of commercial paper and corporate bonds to its portfolio (quantitative easing) to stem rising interest rates. This is all happening because the US Fed seems to have tightened too much and, worse still, continues to tell the world that interest rate hikes are yet to come.

The Fed has more than 300 economists on its staff, and these professionals produce many relevant studies. One of these reports is called the Financial Stability Report and is produced on a semi-annual basis. The latest report, which has just been published, contains a long list of concerns regarding the subject of financial stability. Among them:

• High vacancy rates in commercial real estate
• Margin calls due to rising interest rates
• Defaults on subprime consumer debt
• Bond market liquidity
• Leverage in US shadow banks
• The Chinese real estate market
• US Consumer/Business Financial Distress

This is not a small list of concerns. Yet Fed bosses seem indifferent despite the fact that these problems come from their own staff. We have noted in previous blogs that bond market liquidity was an issue as some large Treasury blocks could not be sold without breaking them into smaller chunks. The mortgage-backed securities (MBS) market has also recently exhibited liquidity problems. The latter two may be partly due to the reduction in the Fed’s balance sheet ($100 billion/month of Treasuries and MBS).

Various

• There are other data points that concern us. The chart shows that banks are reporting significantly weaker demand for mortgages, a theme we have been discussing for several months. Also note that auto loans are weaker (and we note that used car prices have fallen four months in a row), and commercial loans have just turned negative. It’s no surprise that demand for credit cards has increased as consumers seek credit to maintain their standard of living.

• We are seeing supply chain pressures have eased considerably, and this is now showing in the CPI. The first graph is the one we showed in our last blog post and is the supply chain issues poster, i.e. the number of ships waiting to be unloaded in California ports. From an all-time high in February to a recent all-time high.

The second graph shows the cost to move goods across the Pacific. Again, from an all-time high at the start of the year to near normal now.

The third chart shows ISM manufacturing data (supplier lead times and prices), yet another indication that disinflation is in our immediate future.

Final Thoughts

Every indicator we watch tells us the recession has started. These include the latest GDP and employment reports which we have discussed in detail in our last two blogs. The Fed continues its hawkish rhetoric despite all the historical indicators (yield curve inversion, leading economic indicators, internal Fed surveys) telling them that a recession has probably already arrived. This Fed seems oblivious to the havoc its policies have wreaked on the rest of the world (liquidity issues, currency values, etc.) and what the future consequences might be if this world decides that anything other than the dollar should be the world reserve currency.

Last week, there was a run on a crypto exchange, causing that exchange to file for bankruptcy protection. As rates continue to rise, expect more things to break. All this despite the overwhelming evidence that the back of inflation has already been broken. Too bad the Fed looks at inflation through the rearview mirror of Y/Y comparisons instead of looking at the most recent monthly data. Too bad they don’t analyze incoming data, like GDP or employment figures to glean the true underlying trends.

In just a few months, however, the incoming data will be so overwhelming (bad jobs, weak economic growth, melting inflation) that it will have to “pause” and then “pivot”. We believe this will be before mid-2023.

(Joshua Barone contributed to this blog)